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December 17, 2018 |
UK Real Estate Tax – A New Landscape For Investors

Click for PDF This is an interesting time to be a UK citizen, not least because of the unpredictable political situation. However, UK tax policy regarding real estate investment and taxation of real estate structures has been a moving target since before the Brexit referendum. Whether to raise more revenue from the sector or to rectify existing gaps in the legislation, the regular changes to the UK tax rules on real estate indicate confusion amongst policy makers on the best approach. One could credibly accuse HMT and HMRC of reacting piecemeal to issues and not offering a coherent policy which provides certainty and predictability to the sector. Inbound investment is crucial to the present (and future) of the UK economy and the industry is stressing these points to the Government, despite their attention being elsewhere. How we got here Historically, the United Kingdom has always sought to tax non-residents on income which has a UK “source”, such as rent payable on land and buildings in the UK (albeit with deductions for associated revenue expenses, such as interest incurred on related finance). But it has not taxed capital gains realised by non-UK residents in respect of the underlying UK asset. There were exceptions, for example in cases where the land and buildings were held as dealing stock (including as part of a property development business), or where the building was used by the owner as part of the owner’s own operating business (such as a hotel owned by a hotel business). This changed in 2013 with the introduction of the annual tax on enveloped dwellings (ATED), and ATED-related capital gains tax was charged on disposals of “enveloped” residential property. Non-resident capital gains tax (NRCGT) was introduced in 2015 for disposals of closely-owned residential property not caught by the ATED rules. In 2016, the scope of the UK “transactions in land” rules were amended to capture a broader range of profits ultimately derived from property development and dealing in the UK where these had previously fallen outside the scope of the “dealing stock” charge. And there were further refinements to VAT and capital allowances rules impacting the sector, not to mention a wholesale restructuring of the way stamp duty land tax (SDLT) was assessed on property transactions. The Government published a consultative paper in November 2017 proposing that non-resident investors in UK real estate should be brought within the scope of UK tax with effect from April 2019, and draft legislation was published in July 2018. These proposals were modified in the Government’s Budget announcement in November 2018, and a Finance Bill embodying these final proposals is currently before Parliament. This alert reviews the state of the legislation currently before Parliament and summarises the principal changes made since our previous alert. This also includes changes announced in the Budget of which there was no prior notice, which impact the taxation of real estate beyond capital gains. The UK continues to be one of the most mature and diverse real estate markets in the world, but the proposed changes will potentially impact the economic return for overseas investors and therefore such investors may need to adapt their financial models to take into account the relevant new tax charges. 1. DISPOSALS BY NON-UK RESIDENTS OF INVESTMENTS IN UK LAND From April 2019, all non-UK resident persons will be taxable on gains on disposals of interests in any type of UK land or buildings. Changes introduced will apply not only to disposals of directly owned interests in UK land or buildings, but also to disposals of indirectly owned interests, i.e., the sale of interests in entities whose value is derived from UK land and buildings. The Finance Bill amends the existing provisions of the Taxation of Chargeable Gains Act 1992 (TCGA) Part 1 and introduces a new charge to Capital Gains Tax (CGT) or corporation tax on non-UK resident persons making gains on direct or indirect disposals of UK property. What is UK Land? The definition of an interest in UK land in the Finance Bill follows existing definitions under the UK tax code and is designed to capture the whole profits relating to UK land and buildings. To summarise, an “interest in UK land” will include: an estate, interest, right or power in or over land or buildings in the UK; or the benefit of an obligation, restriction or condition affecting the value of an estate, interest, right or power in or over land or buildings in the UK. However, it will not include: licences to use or occupy the land or buildings (e.g., permission to enter or use a building (such as an admission ticket or parking permit), as distinguished from a right attaching to the land, such as a lease – there are difficult cases at the margin; any right or interest held for securing the payment of money or the performance of an obligation (e.g., a right over land held by a bank as security for a loan); and certain other interests (e.g., a tenancy at will or a franchise). Direct Disposals From April 2019, all non-UK residents, whether liable to CGT or corporation tax, will be taxable on gains on disposals of directly held interests in any type of UK land. Indirect Disposals From April 2019, non-UK residents will also be taxed on any gains made on the disposals of significant interests in entities that directly or indirectly own interests in UK land. For tax to be imposed, the entity being disposed of must be “property rich”, and the non-UK resident must be a “substantial investor”. Substantial Investor A non-UK resident is a substantial investor in a property rich entity if, at the date of disposal or at any time within two years prior to disposal, the non-UK resident holds, or has held directly or indirectly, at least a 25% interest in a property rich entity. If the non-UK resident holds the 25% interest for an insignificant time period (relative to the total ownership within two years prior to the disposal), the 25% test will not be met. The 25% interest is determined by voting rights, income rights, rights on a winding up and rights to proceeds on a sale. Property Rich Entities An entity is property rich if at least 75% of the gross market value of its qualifying assets at the time of disposal are derived from UK land. This includes value deriving from any: shareholding in a company deriving its value directly or indirectly from UK land; partnership interests deriving their value directly or indirectly from UK land; interests in property held on trust; and option, consent, or embargo affecting the sale of the UK land. The qualifying asset test includes a complicated matching rule which can exclude some assets (e.g., relevant intercompany loans), and this will lead to the need for valuations for all qualifying assets and not just real estate assets. The Finance Bill contains tracing and attribution of value provisions. Those provisions provide that non-UK residents own an asset deriving 75% of its value from UK land if they: own a right or interest in a company; and at the date of the disposal, at least 75% of the total market value of that company’s qualifying assets derive directly or indirectly from interest in UK land. Deriving the market value of a company will involve tracing through any arrangements and entities (including subsidiaries, partnerships and trusts). When tracing through such arrangements and entities, there must be appropriate attributions to the shareholders, partners and beneficiaries. Trading Exemption Exceptions apply where all of the interests in UK land are used for a qualifying trading purpose (e.g., a factory owned by a manufacturing business). Interests in land that are not used for a qualifying trading purpose are ignored if they are insignificant. A reasonableness test is used to determine what constitutes an “insignificant interest”, taking into account all of the circumstances. Connected Companies Exemption Where two or more companies are disposed of as part of an arrangement and some, but not all, of these companies would meet the 75% property richness test, then special rules apply. If, taken together, the assets of all of the companies aggregated do not meet the 75% property richness test, then none of the companies will be considered to have met the test. Such disposals by non-UK residents will therefore fall outside the changes brought in by the Finance Bill to UK tax on capital gains. Anti-avoidance The Finance Bill also introduces anti-avoidance provisions that apply to the new rules on indirect disposals by non-UK residents of UK land. These rules apply where the non-UK resident tax payer enters into an arrangement, the main purpose of which (or one of the main purposes of which) is to obtain a tax advantage and either: the tax advantage relates to tax for which that person would be liable (but for the arrangement) under the CGT regime and the arrangements were entered into on or after 6 July 2018; or the advantage arises in the context of a double taxation arrangement (i.e., a “treaty shopping case”) and the arrangements were entered into on or after 22 November 2017. Re-basing There are now two key re-basing dates: 5 April 2015 and 5 April 2019. The default date for re-basing is identified by determining whether the non-UK resident disposal falls within one of the below categories: Directly held commercial property: Non-UK residents disposing of UK commercial property directly held at 5 April 2019 may re-base the land to its 5 April 2019 market value or elect to use the original base cost. Where a taxpayer takes the latter approach, any loss arising will not be an allowable loss. Directly held residential property within NRCGT or ATED: Non-UK residents disposing of UK residential property directly held since 6 April 2015 and chargeable to CGT prior to 6 April 2019 (i.e., UK land that was subject to the non-resident CGT regime or that would have been subject to ATED-related CGT had it been disposed of on or before 5 April 2019), may re-base the land to its 5 April 2015 market value or elect to use the original base cost. Alternatively, the taxpayer may elect for a straight-line time apportionment of any gain. Directly held residential property outside NRCGT or ATED: Non-UK residents disposing of UK residential property directly held at 5 April 2019 that was not chargeable on or before this date (i.e., residential property held by widely held non-UK resident companies, widely marketed collective investment schemes or non-UK resident life assurance businesses) may re-base the land to its 5 April 2019 market value or elect to use the original base cost. Where a taxpayer takes the latter approach, any loss arising will not to be an allowable loss. Directly held mixed use property: Non-UK residents disposing of UK mixed use (i.e., commercial and residential use) property directly held since 6 April 2015 and partly chargeable to CGT prior to 6 April 2019, may re-base the land to its 5 April 2015 market value and then again to its 5 April 2019 market value. The amount of any gain or loss accrued on the residential element on the re-basing to its 5 April 2019 market value is brought into charge to tax on the eventual sale. The non-UK resident taxpayer also has the option of using the original base cost, rather than re-basing the asset value. Indirect interests: Non-UK residents disposing of UK property indirectly held  (i.e., through one or more corporate entities) will rebase the shares to their 5 April 2019 market value or elect to use the original base cost. Where a taxpayer takes the latter approach, any loss arising will not be an allowable loss. Corporation Tax The UK property activities of non-UK resident companies will be brought within the scope of UK corporation tax from April 2020. They will be subject to UK corporation tax (rather than income tax) on their income from UK land from April 2020 – at which point the main corporation tax rate will be 17%. The delay in bringing companies within the corporation tax regime means the application of corporate interest restriction rules, hybrid rules and limits to carried forward losses are equally delayed. However, companies will not be able to take advantage of the lower tax rate until such time. Such companies will, from April 2020, become entitled to benefit from corporation tax reliefs such as the substantial shareholding exemption (SSE) and the no-gain, no-loss rules on intragroup asset transfers. One point to note is the interaction of SSE and the corporate interest restriction rules. The Public Benefit Infrastructure Exemption (PBIE) provides a more generous interest deduction than the standard debt cap – and it is available to some owners of UK investment property. However, companies eligible to benefit from SSE are unlikely to be able to benefit from PBIE (and vice versa). Where it is possible to structure ownership of a property in a manner that could benefit from either PBIE or SSE, a choice will need to be made at the time the property is acquired as to which relief is likely to be more valuable. There will be many situations involving indirect disposals where SSE may not be applied (e.g., on the disposal of a benefit of a debt or derivative deriving its value from UK land). Where SSE is not available, the application of the trading exemption (see above) will be crucial. Reliefs SSE is not available to non-corporate taxpayers (such as individuals and trustees). As noted above, where SSE is not available, the application of the trading exemption will be crucial. It is not clear whether roll-over relief for capital reorganisations will be permitted if interests are exchanged in a property rich entity in consideration of the issue of interests in an acquisition vehicle which is not property rich. Those who are exempt from capital gains for reasons other than being non-UK resident (e.g., pension funds and sovereign wealth funds) will continue to be exempt under the new rules. Availability of losses Losses arising to non-UK resident companies under the new rules will be available in the same way as capital losses for UK resident companies. CGT losses will follow the existing rules for NRCGT losses. NRCGT losses and ring-fenced ATED-related allowable losses accruing to a non-UK resident company before 6 April 2019 are deductible from any corporation tax due by the non-UK resident on chargeable gains (to the extent they have not already been deducted from gains). See also section 4 of this alert for further details on losses. Collective Investment Vehicles The default position for collective investment vehicles (CIV) will be that they are treated for capital gains purposes as if they were companies. The CIV definition in the legislation is broad, and should capture most UK property rich Jersey Property Unit Trusts (JPUTs) and Guernsey Property Unit Trusts (GPUTs), as well as widely-held offshore funds. An investment in such a fund will be treated as if the interests of the investors were shares in a company, so that where the fund is UK property rich, a disposal of an interest in it by a non-UK resident investor will be chargeable to UK tax under the new rules. But the deeming provisions will not go as far as treating CIVs as having ordinary share capital, so they will not be able to rely on provisions or reliefs that require a relationship to be established between a parent and subsidiary, or common subsidiaries of a parent, through ownership of ordinary share capital. One consequence of CIVs being treated as companies is that they will be subject to corporation tax after April 2020. Non-Application of 25% Ownership Exemption for CIVs Non-UK resident investors in CIVs that are UK property rich will be chargeable on gains on disposals of an interest in a UK property rich CIV regardless of their level of investment. They will not benefit from the 25% ownership threshold. The usual 25% substantial indirect interest test may be re-applied for certain funds where the CIV is only temporarily UK property rich. In these cases, the fund will need to meet a genuine diversity of ownership or non-close test, and be targeting UK property investments of no more than 40% of fund gross asset value in accordance with its prospectus or other fund documents. The Transparency Election CIVs that are already treated as transparent for tax purposes will be able to elect (irrevocably) to be treated as a partnership for the purposes of capital gains (and related provisions), thereby ensuring that the investors are taxed on disposals of the underlying assets of the partnership. Statement of Practice D12 (SP D12), and the usual taxation of partnership rules, will apply in calculating any gain or loss when the investor or the CIV makes a disposal. An investor who is exempt from capital gains (e.g., pension funds and sovereign wealth funds) would therefore be able to directly claim exemption on the disposal of assets by the CIV. In the case of a fund existing at 6 April 2019, the election must be made by 5 April 2020. The election can be made by the fund manager, and must be accompanied by the consent of all of the investors in the fund at the time of making the election. The investors’ consent may be assumed where it is evident that it has been made clear to investors that they are buying an interest in a fund that intends to make a transparency election. To qualify for the transparency exemption, the CIV will need to either be UK property rich at the time of the election, or have published scheme documents at that time clearly stating the intention of the CIV to invest predominantly in UK land. The transparency exemption is unlikely to be appropriate for CIVs that have regular changes of investors, as these changes may trigger regular disposals of other investors’ interests in the underlying assets because of the way in which SP D12 deals with the introduction and withdrawal of partners in a partnership. The Exemption Election Under the election for exemption, the CIV itself will not suffer tax on either direct or indirect disposals on the proportion of any gains attributable to the CIV holding UK land. The investors remain taxable under first principles on any disposal of an interest in a CIV that is a UK property rich entity. The election for exemption is not available to all funds. It is only available to non-UK resident companies that are the equivalent of UK REITs and some partnerships. An extensive set of qualifying criteria needs to be met in order to be able to make the election for exemption. In particular, these include a requirement for diverse ownership of the CIV. Where a CIV ceases to meet any of the qualifying criteria, this will trigger a deemed disposal and reacquisition of the interests of all the investors in the CIV. Certain reporting obligations apply in these instances. Tricky provisions apply where the CIV falls in and out of the conditions over certain periods of time. CIV Reporting Obligations Not only will CIVs and investors in the CIVs need to understand the new tax regime, they will also need to understand the new reporting obligations. CIVs will be required to make annual filings with HMRC providing details of the CIVs’ investors and disposals (if any). For CIVs established prior to 1 June 2019 there are dispensations in the information required where the manager is otherwise prevented from providing such information to HMRC for legal, regulatory or contractual reasons and so fund managers will need to review their constitutional documents to see if the obligations apply. 2. REPORTING AND PAYMENTS ON ACCOUNT OF CAPITAL GAINS With effect from 6 April 2019, disposals of UK land by non-UK resident persons must be reported within 30 days of completion, and payment on account of the tax liability must be made by the same date. This 30-day time limit also applies to disposals made by non-UK resident investors in CIVs. Where a fund is fiscally transparent, arrangement will need to be in place for fund managers to notify their investors when disposals occur. With effect from 6 April 2020, direct disposals of UK land on which a residential property gain accrues (by both UK residents and non-residents) must be reported within 30 days of completion, and payment on account of the tax liability must be made by the same date. 3. ANNUAL TAX ON ENVELOPED DWELLINGS ATED-related CGT will be abolished with effect from April 2019, as the new rules set out in section 1 of this alert would now cover disposals that would otherwise have been caught under the ATED-related CGT provisions. ATED will continue to apply as an annual tax. The rates of ATED will increase by 2.4% (in line with the consumer prices index) with effect from 1 April 2019. 4. CORPORATE CAPITAL LOSS RESTRICTION To ensure that large UK companies pay tax when they make significant capital gains, new rules will bring the tax treatment of corporate capital losses into line with the treatment of income losses. From 1 April 2020, the proportion of annual capital gains that can be relieved by brought-forward capital losses will be restricted to 50%. This will be relevant to non-UK resident property companies, when they come within the charge to UK corporation tax in April 2020. The measure will include an allowance that gives companies unrestricted use of up to £5 million capital or income losses each year. The measure will be subject to anti-avoidance rules that apply with effect from 29 October 2018. 5. CAPITAL ALLOWANCES The Finance Bill includes provisions for a new form of capital allowance relating to costs incurred in the construction, conversion or renovation of new commercial property – to be known as Structures and Buildings Allowance. The Structures and Buildings Allowance is subject to consultation, but it is expected to be given at a flat rate of 2% per annum over a 50-year period. The Finance Bill also includes the following additional provisions: An increase to the Annual Investment Allowance from £200,000 to £1 million from 1 January 2019 until 31 December 2020. A reduction of the capital allowances special rate from 8% to 6% from April 2019. The main pool rate will remain at 18%. An end to the Enhanced Capital Allowances and First Year Tax Credits for technologies on the Energy Technology List and Water Technology List from April 2020. An extension to the first year allowance for electric charge-points for four years until April 2023. 6. STAMP DUTY LAND TAX For transactions completed on or after 1 March 2019, the filing deadline for SDLT returns and the payment of SDLT will be reduced from 30 days to 14 days. The Government intends to consult on introducing a new 1% SDLT surcharge on the acquisition of residential property in England and Northern Ireland by non-UK residents. The consultation document will be published in January 2019. 7. VAT REVERSE CHARGE FOR BUILDING AND CONSTRUCTION SERVICES The Finance Bill introduces a VAT reverse charge on certain building and construction services that will come into effect on 1 October 2019. These rules are intended to reduce tax fraud within the construction industry where sub-contractors charge VAT, but disappear without accounting for HMRC for such VAT. The new rules will, in many cases, require the recipient of the supply of construction services (rather than the supplier) to account for VAT on the supply. The reverse charge will apply through the supply chain where payments are required to be reported through the Construction Industry Scheme up to the point where the customer receiving the supply is no longer a business that makes supplies of specified services, i.e., “end users”. 8. INTERNATIONAL TAX ENFORCEMENT: DISCLOSABLE ARRANGEMENTS The Finance Bill includes powers for the Government to make regulations to implement Council Directive 2018/822/EU (DAC6), which requires EU intermediaries (including banks, accounting firms, law firms, corporate service providers and certain other persons) involved in cross-border arrangements to make a disclosure to their tax authority if certain requirements are met. DAC6 is intended to give tax authorities early notice of new cross-border tax or avoidance schemes. This is intended to enable the authorities to investigate users and, if necessary, close down the schemes with legislative changes. DAC6 is widely drafted and clients with cross-border arrangements anywhere in the EU are advised to check whether arrangements entered into from June 2018 do not trigger a notification requirement. CONCLUSION As set out above, numerous tax changes have or will be implemented, each of which could impact the economic return for overseas investors with interests in UK real estate. Investors should consider the different UK tax implications that result from investing in such assets directly and indirectly. It will also be important to bear in mind that the nature of any potential transaction (and the level in the relevant structure at which the transaction occurs), as well as the type of entities involved, could create differences in the tax result and there may be no obvious policy reason as to why this should be the case. Therefore, investors will need to consider their individual positions accordingly. For example, the draft NRCGT legislation is intended to more closely align the tax treatment of non-UK residents with that of UK residents. Whether this is actually the case is very much open to debate. The funds industry was initially very concerned about this proposal, particularly given that funds and joint ventures are often structured to facilitate tax-exempt investors investing alongside taxable investors in such a way that no more tax is paid than if they acquired any assets directly. The original draft rules could have taxed such structures at multiple levels and various changes to the draft legislation have sought to address this, but some gaps and concerns still remain. It will also be important to monitor the ongoing efforts to bring non-resident property companies within the corporation tax regime from April 2020, as there remain a number of technical issues to be finalised, as well as fundamental differences in how capital gains are calculated depending on which part of the UK tax code an entity falls within (e.g., indexation for corporation tax payers). Gibson Dunn’s lawyers are available to assist with any questions you may have regarding these developments. For further information, please contact the Gibson Dunn lawyer with whom you usually work or any of the following members of the Tax Practice Group: Sandy Bhogal – London (+44 (0) 20 7071 4266, sbhogal@gibsondunn.com) Nicholas Aleksander – London (+44 (0)20 7071 4232, naleksander@gibsondunn.com) © 2018 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

November 28, 2018 |
Law360 Names Eight Gibson Dunn Partners as MVPs

Law360 named eight Gibson Dunn partners among its 2018 MVPs and noted that the firm had the most MVPs of any law firms this year.  Law360 MVPs feature lawyers who have “distinguished themselves from their peers by securing hard-earned successes in high-stakes litigation, complex global matters and record-breaking deals.” Gibson Dunn’s MVPs are: Christopher Chorba, a Class Action MVP [PDF] – Co-Chair of the firm’s Class Actions Group and a partner in our Los Angeles office, he defends class actions and handles a broad range of complex commercial litigation with an emphasis on claims involving California’s Unfair Competition and False Advertising Laws, the Consumers Legal Remedies Act, the Lanham Act, and the Class Action Fairness Act of 2005. His litigation and counseling experience includes work for companies in the automotive, consumer products, entertainment, financial services, food and beverage, social media, technology, telecommunications, insurance, health care, retail, and utility industries. Michael P. Darden, an Energy MVP [PDF] – Partner in charge of the Houston office, Mike focuses his practice on international and U.S. oil & gas ventures and infrastructure projects (including LNG, deep-water and unconventional resource development projects), asset acquisitions and divestitures, and energy-based financings (including project financings, reserve-based loans and production payments). Thomas H. Dupree Jr., an MVP in Transportation [PDF] –  Co-partner in charge of the Washington, DC office, Tom has represented clients in a wide variety of trial and appellate matters, including cases involving punitive damages, class actions, product liability, arbitration, intellectual property, employment, and constitutional challenges to federal and state statutes.  He has argued more than 80 appeals in the federal courts, including in all 13 circuits as well as the United States Supreme Court. Joanne Franzel, a Real Estate MVP [PDF] – Joanne is a partner in the New York office, and her practice has included all forms of real estate transactions, including acquisitions and dispositions and financing, as well as office and retail leasing with anchor, as well as shopping center tenants. She also has represented a number of clients in New York City real estate development, representing developers as well as users in various mixed-use projects, often with a significant public/private component. Matthew McGill, an MVP in the Sports category [PDF] – A partner in the Washington, D.C. office, Matt practices appellate and constitutional law. He has participated in 21 cases before the Supreme Court of the United States, prevailing in 16. Spanning a wide range of substantive areas, those representations have included several high-profile triumphs over foreign and domestic sovereigns. Outside the Supreme Court, his practice focuses on cases involving novel and complex questions of federal law, often in high-profile litigation against governmental entities. Mark A. Perry, an MVP in the Securities category [PDF] – Mark is a partner in the Washington, D.C. office and is Co-chair of the firm’s Appellate and Constitutional Law Group.  His practice focuses on complex commercial litigation at both the trial and appellate levels. He is an accomplished appellate lawyer who has briefed and argued many cases in the Supreme Court of the United States. He has served as chief appellate counsel to Fortune 100 companies in significant securities, intellectual property, and employment cases.  He also appears frequently in federal district courts, serving both as lead counsel and as legal strategist in complex commercial cases. Eugene Scalia, an Appellate MVP [PDF] – A partner in the Washington, D.C. office and Co-Chair of the Administrative Law and Regulatory Practice Group, Gene has a national practice handling a broad range of labor, employment, appellate, and regulatory matters. His success bringing legal challenges to federal agency actions has been widely reported in the legal and business press. Michael Li-Ming Wong, an MVP in Cybersecurity and Privacy [PDF] – Michael is a partner in the San Francisco and Palo Alto offices. He focuses on white-collar criminal matters, complex civil litigation, data-privacy investigations and litigation, and internal investigations. Michael has tried more than 20 civil and criminal jury trials in federal and state courts, including five multi-week jury trials over the past five years.

November 21, 2018 |
Gibson Dunn Ranked in the 2019 UK Legal 500

The UK Legal 500 2019 ranked Gibson Dunn in 13 practice areas and named six partners as Leading Lawyers. The firm was recognized in the following categories: Corporate and Commercial: Equity Capital Markets Corporate and Commercial: M&A – Upper Mid-Market and Premium Deals, £250m+ Corporate and Commercial: Private Equity – High-value Deals Dispute Resolution: Commercial Litigation Dispute Resolution: International Arbitration Finance: Acquisition Finance Finance: Bank Lending: Investment Grade Debt and Syndicated Loans Human Resources: Employment – Employers Public Sector: Administrative and Public Law Real Estate: Commercial Property – Hotels and Leisure Real Estate: Commercial Property – Investment Real Estate: Property Finance Risk Advisory: Regulatory Investigations and Corporate Crime The partners named as Leading Lawyers are Sandy Bhogal – Corporate and Commercial: Corporate Tax; Steve Thierbach – Corporate and Commercial: Equity Capital Markets; Philip Rocher – Dispute Resolution: Commercial Litigation; Cyrus Benson – Dispute Resolution: International Arbitration; Jeffrey Sullivan – Dispute Resolution: International Arbitration; and Alan Samson – Real Estate: Commercial Property and Real Estate: Property Finance. Claibourne Harrison has also been named as a Next Generation Lawyer for Real Estate: Commercial Property.

November 2, 2018 |
Gibson Dunn Ranked in Chambers UK 2019

Gibson Dunn was recognized with two firm and 14 individual rankings in the 2019 edition of Chambers UK.  The firm was recognized in the categories: International Arbitration – UK-wide and Real Estate Finance – London.  The following partners were recognized in their respective practice areas:  Cyrus Benson in International Arbitration – UK-wide, Sandy Bhogal in Tax – London, James Cox in Employment: Employer – London, Charlie Geffen in Corporate/M&A: High End – London and Private Equity – UK-wide, Chris Haynes in Capital Markets: Equity – UK-wide, Anna Howell in Energy & Natural Resources: Oil & Gas – UK-wide, Penny Madden in International Arbitration – UK-wide, Ali Nikpay in Competition Law – London, Alan Samson in Real Estate – London and Real Estate Finance – London, Jeff Sullivan in International Arbitration – UK-wide and Public International Law – London, and Steve Thierbach in Capital Markets: Equity – UK-wide.

November 1, 2018 |
U.S. News – Best Lawyers® Awards Gibson Dunn 132 Top-Tier Rankings

U.S. News – Best Lawyers® awarded Gibson Dunn Tier 1 rankings in 132 practice area categories in its 2019 “Best Law Firms” [PDF] survey. Overall, the firm earned 169 rankings in nine metropolitan areas and nationally. Additionally, Gibson Dunn was recognized as “Law Firm of the Year” for Litigation – Antitrust and Litigation – Securities. Firms are recognized for “professional excellence with persistently impressive ratings from clients and peers.” The recognition was announced on November 1, 2018.

October 22, 2018 |
IRS Provides Much Needed Guidance on Opportunity Zones through Issuance of Proposed Regulations

Click for PDF On October 19, 2018, the Internal Revenue Service (the “IRS“) and the Treasury Department issued proposed regulations (the “Proposed Regulations“) providing rules regarding the establishment and operation of “qualified opportunity funds” and their investment in “opportunity zones.”[1]  The Proposed Regulations address many open questions with respect to qualified opportunity funds, while expressly providing in the preamble that additional guidance will be forthcoming to address issues not resolved by the Proposed Regulations.  The Proposed Regulations should provide investors, sponsors and developers with the answers needed to move forward with projects in opportunity zones. Opportunity Zones Qualified opportunity funds were created as part of the tax law signed into law in December 2017 (commonly known as the Tax Cuts and Jobs Act (“TCJA“)) to incentivize private investment in economically underperforming areas by providing tax benefits for investments through qualified opportunity funds in opportunity zones.  Opportunity zones are low-income communities that were designated by each of the States as qualified opportunity zones – as of this writing, all opportunity zones have been designated, and each designation remains in effect from the date of designation until the end of the tenth year after such designation. Investments in qualified opportunity funds can qualify for three principal tax benefits: (i) a temporary deferral of capital gains that are reinvested in a qualified opportunity fund, (ii) a partial exclusion of those reinvested capital gains on a sliding scale and (iii) a permanent exclusion of all gains realized on an investment in a qualified opportunity fund that is held for a ten-year period. In general, all capital gains realized by a person that are reinvested within 180 days of the recognition of such gain in a qualified opportunity fund for which an election is made are deferred for U.S. federal income tax purposes until the earlier of (i) the date on which such investment is sold or exchanged and (ii) December 31, 2026. In addition, an investor’s tax basis in a qualified opportunity fund for purposes of determining gain or loss, is increased by 10 percent of the amount of gain deferred if the investment is held for five years prior to December 31, 2026 and is increased by an additional 5 percent (for a total increase of 15 percent) of the amount of gain deferred if the investment is held for seven years prior to December 31, 2026. Finally, for investments in a qualified opportunity fund that are attributable to reinvested capital gains and held for at least 10 years, the basis of such investment is increased to the fair market value of the investment on the date of the sale or exchange of such investment, effectively eliminating any gain (other than the deferred gain that was reinvested in the qualified opportunity fund and taxable or excluded as described above) in the investment for U.S. federal income tax purposes (such benefit, the “Ten Year Benefit“). A qualified opportunity fund, in general terms, is a corporation or partnership that invests at least 90 percent of its assets in “qualified opportunity zone property,” which is defined under the TCJA as “qualified opportunity zone business property,” “qualified opportunity zone stock” and “qualified opportunity zone partnership interests.”  Qualified opportunity zone business property is tangible property used in a trade or business within an opportunity zone if, among other requirements, (i) the property is acquired by the qualified opportunity fund by purchase, after December 31, 2017, from an unrelated person, (ii) either the original use of the property in the opportunity zone commences with the qualified opportunity fund or the qualified opportunity fund “substantially improves” the property by doubling the basis of the property over any 30 month period after the property is acquired and (iii) substantially all of the use of the property is within an opportunity zone.  Essentially, qualified opportunity zone stock and qualified opportunity zone partnership interests are stock or interests in a corporation or partnership acquired in a primary issuance for cash after December 31, 2017 and where “substantially all” of the tangible property, whether leased or owned, of the corporation or partnership is qualified opportunity zone business property. The Proposed Regulations – Summary and Observations The powerful tax incentives provided by opportunity zones attracted substantial interest from investors and the real estate community, but many unresolved questions have prevented some taxpayers from availing themselves of the benefits of the law.  A few highlights from the Proposed Regulations, as well as certain issues that were not resolved, are outlined below. Capital Gains The language of the TCJA left open the possibility that both capital gains and ordinary gains (e.g., dealer income) could qualify for deferral if invested in a qualified opportunity fund.  The Proposed Regulations provide that only capital gains, whether short-term or long-term, qualify for deferral if invested in a qualified opportunity fund and further provide that when recognized, any deferred gain will retain its original character as short-term or long-term. Taxpayer Entitled to Deferral The Proposed Regulations make clear that if a partnership recognizes capital gains, then the partnership, and if the partnership does not so elect, the partners, may elect to defer such capital gains.  In addition, the Proposed Regulations provide that in measuring the 180-day period by which capital gains need to be invested in a qualified opportunity fund, the 180-day period for a partner begins on the last day of the partnership’s taxable year in which the gain is recognized, or if a partner elects, the date the partnership recognized the gain.  The Proposed Regulations also state that rules analogous to the partnership rules apply to other pass-through entities, such as S corporations. Ten Year Benefit The Ten Year Benefit attributable to investments in qualified opportunity funds will be realized only if the investment is held for 10 years.  Because all designations of qualified opportunity zones under the TCJA automatically expire no later than December 31, 2028, there was some uncertainly as to whether the Ten Year Benefit applied to investments disposed of after that date.  The Proposed Regulations expressly provide that the Ten Year Benefit rule applies to investments disposed of prior to January 1, 2048. Qualified Opportunity Funds The Proposed Regulations generally provide that a qualified opportunity fund is required to be classified as a corporation or partnership for U.S. federal income tax purposes, must be created or organized in one of the 50 States, the District of Columbia, or, in certain cases a U.S. possession, and will be entitled to self-certify its qualification to be a qualified opportunity fund on an IRS Form 8996, a draft form of which was issued contemporaneously with the issuance of the Proposed Regulations. Substantial Improvements Existing buildings in qualified opportunity zones generally will qualify as qualified opportunity zone business property only if the building is substantially improved, which requires the tax basis of the building to be doubled in any 30-month period after the property is acquired.  In very helpful rule for the real estate community, the Proposed Regulations provide that, in determining whether a building has been substantially improved, any basis attributable to land will not be taken into account.  This rule will allow major renovation projects to qualify for qualified opportunity zone tax benefits, rather than just ground up development.  This rule will also place a premium on taxpayers’ ability to sustain a challenge to an allocation of purchase price to land versus improvements. Ownership of Qualified Opportunity Zone Business Property In order for a fund to qualify as a qualified opportunity fund, at least 90 percent of the fund’s assets must be invested in qualified opportunity zone property, which includes qualified opportunity zone business property.  For shares or interests in a corporation or partnership to qualify as qualified opportunity zone stock or a qualified opportunity zone partnership interest, “substantially all” of the corporation’s or partnership’s assets must be comprised of qualified opportunity zone business property. In a very helpful rule, the Proposed Regulations provide that cash and other working capital assets held for up to 31 months will count as qualified opportunity zone business property, so long as (i) the cash and other working capital assets are held for the acquisition, construction and/or or substantial improvement of tangible property in an opportunity zone, (ii) there is a written plan that identifies the cash and other working capital as held for such purposes, and (iii) the cash and other working capital assets are expended in a manner substantially consistent with that plan. In addition, the Proposed Regulations provide that for purposes of determining whether “substantially all” of a corporation’s or partnership’s tangible property is qualified opportunity zone business property, only 70 percent of the tangible property owned or leased by the corporation or partnership in its trade or business must be qualified opportunity zone business property. Qualified Opportunity Funds Organized as Tax Partnerships Under general partnership tax principles, when a partnership borrows money, the partners are treated as contributing money to the partnership for purposes of determining their tax basis in their partnership interest.  As a result of this rule, there was uncertainty regarding whether investments by a qualified opportunity fund that were funded with debt would result in a partner being treated, in respect of the deemed contribution of money attributable to such debt, as making a contribution to the partnership that was not in respect of reinvested capital gains and, thus, resulting in a portion of such partner’s investment in the qualified opportunity fund failing to qualify for the Ten Year Benefit.  The Proposed Regulations expressly provide that debt incurred by a qualified opportunity fund will not impact the portion of a partner’s investment in the qualified opportunity fund that qualifies for the Ten Year Benefit. The Proposed Regulations did not address many of the other open issues with respect to qualified opportunity funds organized as partnerships, including whether investors are treated as having sold a portion of their interest in a qualified opportunity fund and thus can enjoy the Ten Year Benefit if a qualified opportunity fund treated as a partnership and holding multiple investments disposes of one or more (but not all) of its investments.  Accordingly, until further guidance is issued, we expect to see most qualified opportunity funds organized as single asset corporations or partnerships. Effective Date In general, taxpayers are permitted to rely upon the Proposed Regulations so long as they apply the Proposed Regulations in their entirety and in a consistent manner.    [1]   Prop. Treas. Reg. §1.1400Z-2 (REG-115420-18). Gibson Dunn’s lawyers are available to assist with any questions you may have regarding these developments.  For further information, please contact the Gibson Dunn lawyer with whom you usually work, any member of the Tax Practice Group, or the following authors: Brian W. Kniesly – New York (+1 212-351-2379, bkniesly@gibsondunn.com) Paul S. Issler – Los Angeles (+1 213-229-7763, pissler@gibsondunn.com) Daniel A. Zygielbaum – New York (+1 202-887-3768, dzygielbaum@gibsondunn.com) Please also feel free to contact any of the following leaders and members of the Tax practice group: Jeffrey M. Trinklein – Co-Chair, London/New York (+44 (0)20 7071 4224 / +1 212-351-2344), jtrinklein@gibsondunn.com) David Sinak – Co-Chair, Dallas (+1 214-698-3107, dsinak@gibsondunn.com) David B. Rosenauer – New York (+1 212-351-3853, drosenauer@gibsondunn.com) Eric B. Sloan – New York (+1 212-351-2340, esloan@gibsondunn.com) Romina Weiss – New York (+1 212-351-3929, rweiss@gibsondunn.com) Benjamin Rippeon – Washington, D.C. (+1 202-955-8265, brippeon@gibsondunn.com) Hatef Behnia – Los Angeles (+1 213-229-7534, hbehnia@gibsondunn.com) Dora Arash – Los Angeles (+1 213-229-7134, darash@gibsondunn.com) Scott Knutson – Orange County (+1 949-451-3961, sknutson@gibsondunn.com) © 2018 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

October 18, 2018 |
Webcast: CFIUS Reform and the Implications for Real Estate Transactions

On August 13, 2018, President Trump signed legislation that will significantly expand the scope of inbound foreign real estate investments subject to review by the Committee on Foreign Investment in the United States (“CFIUS” or “the Committee”).  The Foreign Investment Risk Review Modernization Act (“FIRRMA”) provides CFIUS with authority to review real estate transactions—including leases, sales, and concessions—involving air or maritime ports or in close proximity to sensitive U.S. government facilities.  In this CLE webcast presentation, Gibson Dunn attorneys discuss the Committee’s view of relevant national security risks and anticipated implementing regulations for such transactions. Topics to be covered: CFIUS Overview National Security Risks Associated with Real Estate Transaction FIRRMA’s Real Estate Provisions Impact on Real Estate Investments and Transactions View Slides [PDF] PANELISTS: Judith Alison Lee, a partner in our Washington, D.C. office, is Co-Chair of the firm’s International Trade Practice Group. She practices in the areas of international trade regulation, including USA Patriot Act compliance, economic sanctions and embargoes, export controls, and national security reviews (“CFIUS”). She also advises on issues relating to virtual and digital currencies, blockchain technologies and distributed cryptoledgers. Jose W. Fernandez, a partner in our New York office and Co-Chair of the firm’s Latin America Practice Group, previously served as Assistant Secretary of State for Economic, Energy and Business Affairs during the Obama Administration, and led the Bureau that is responsible for overseeing work on sanctions and international trade and investment policy. His practice focuses on mergers and acquisitions and finance in emerging markets in Latin America, the Middle East, Africa and Asia. Andrew A. Lance, a partner in our New York office, is Co-Head of the Real Estate Practice Group’s Hotel and Hospitality Practice. His practice focuses on real estate capital markets, transactional and finance matters, including rated commercial real estate structured financings, multistate mortgage financings, mezzanine financing, management and finance. Stephanie L. Connor, a senior associate in the Washington D.C. office, practices primarily in the areas of international trade compliance and white collar investigations. She focuses on matters before the U.S. Committee on Foreign Investment in the United States (“CFIUS”) and has served on secondment to the Legal and Compliance division of a Fortune 100 company. MCLE CREDIT INFORMATION: This program has been approved for credit in accordance with the requirements of the New York State Continuing Legal Education Board for a maximum of 1.50 credit hours, of which 1.50 credit hours may be applied toward the areas of professional practice requirement. This course is approved for transitional/non-transitional credit. Gibson, Dunn & Crutcher LLP certifies that this activity has been approved for MCLE credit by the State Bar of California in the amount of 1.25 hours. Gibson, Dunn & Crutcher LLP is authorized by the Solicitors Regulation Authority to provide in-house CPD training. This program is approved for CPD credit in the amount of 1.25 hours. Regulated by the Solicitors Regulation Authority (Number 324652). Application for approval is pending with the Colorado, Texas and Virginia State Bars. Most participants should anticipate receiving their certificates of attendance via e-mail in approximately 4 to 6 weeks following the webcast. Members of the Virginia Bar should anticipate receiving the applicable certification forms in approximately 6 to 8 weeks.

October 11, 2018 |
Financing Arrangements and Documentation: Considerations Ahead of Brexit

Click for PDF Since the result of the Brexit referendum was announced in June 2016, there has been significant commentary regarding the potential effects of the UK’s withdrawal from the EU on the financial services industry. As long as the UK is negotiating its exit terms, a number of conceptual questions facing the sector still remain, such as market regulation and bank passporting. Many commentators have speculated from a ‘big picture’ perspective what the consequences will be if / when exit terms are agreed.  From a contractual perspective, the situation is nuanced. This article will consider certain areas within English law financing documentation which may or may not need to be addressed. Bank passporting The EU “passporting” regime has been the subject of much commentary since the result of the Brexit referendum.  In short, in some EU member states, lenders are required under domestic legislation to have licences to lend.  Many UK lenders have relied on EU passporting (currently provided for in MiFID II), which allows them to lend into EU member states simply by virtue of being regulated in the UK (and vice versa). The importance for the economy of the passporting regime is clear. Unless appropriate transitional arrangements are put in place to ensure that the underlying principle survives, however, there is a risk that following Brexit passporting could be lost.  Recent materials produced by the UK Government suggest that the loss of passporting may be postponed from March 2019 until the end of 2020, although financial institutions must still consider what will happen after 2020 if no replacement regime is agreed.  The UK Government has committed to legislate (if required) to put in place a temporary recognition regime to allow EU member states to continue their financial services in the UK for a limited time (assuming there is a “no deal” scenario and no agreed transition period). However, there has not to date been a commitment from the EU to agree to a mirror regime. Depending on the outcome of negotiations on passporting, financial institutions will need to consider the regulatory position in relation to the performance of their underlying financial service, whether that is: lending, issuance of letters of credit / guarantees, provision of bank accounts or other financial products, or performing agency / security agency roles. Financial institutions may need to look to transfer their participations to an appropriately licensed affiliate (if possible) or third party, change the branch through which it acts, resign from agency or account bank functions, and/or exit the underlying transaction using the illegality protections (although, determining what is “unlawful” for these purposes in terms of a lender being able to fund or maintain a loan will be a complex legal and factual analysis).  More generally, we expect these provisions to be the subject of increasing scrutiny, although there seems to be limited scope for lenders to move illegality provisions in their favour and away from an actual, objective illegality requirement, owing to long-standing commercial convention. From a documentary perspective, it will be necessary to analyse loan agreements individually to determine whether any provisions are invoked and/or breached, and/or any amendments are required.  For on-going structuring, it may be appropriate for facilities to be tranched – such tranches (to the extent the drawing requirements of international obligor group can be accurately determined ahead of time) being “ring-fenced”, with proportions of a facility made available to different members of the borrower group and to be participated in by different lenders – or otherwise structured in an alternative, inventive manner – for example, by “fronting” the facility with a single, adequately regulated lender with back-to-back lending mechanics (e.g. sub-participation) standing behind.  In the same way, we also expect that lenders will exert greater control – for example by requiring all lender consent in all instances – on the accession of additional members of the borrowing group to existing lending arrangements in an attempt to diversify the lending jurisdictions.  Derivatives If passporting rights are lost and transitional relief is not in place, this could have a significant impact on the derivatives markets.  Indeed, without specific transitional or equivalence agreements in place between the EU and the UK, market participants may not be able to use UK clearing houses to clear derivatives subject to mandatory clearing under EMIR.  Additionally, derivatives executed on UK exchanges could be viewed as “OTC derivatives” under EMIR and would therefore be counted towards the clearing thresholds under EMIR.  Further, derivatives lifecycle events (such as novations, amendments and portfolio compressions) could be viewed as regulated activities thereby raising questions about enforceability and additional regulatory restrictions and requirements. In addition to issues arising between EU and UK counterparties, equivalence agreements in the derivatives space between the EU and other jurisdictions, such as the United States, would not carry over to the UK.  Accordingly, the UK must put in place similar equivalence agreements with such jurisdictions or market participants trading with UK firms could be at a disadvantage compared to those trading with EU firms. As a result of the uncertainty around Brexit and the risk that passporting rights are likely to be lost, certain counterparties are considering whether to novate their outstanding derivatives with UK derivatives entities to EU derivatives entities ahead of the exit date.  Novating derivatives portfolios from a UK to an EU counterparty is a significant undertaking involving re-documentation, obtaining consents, reviewing existing documentation, identifying appropriate counterparties, etc. EU legislation and case law Loan agreements often contain references to EU legislation or case law and, therefore, it is necessary to consider whether amendments are required. One particular area to be considered within financing documentation is the inclusion of Article 55 Bail-In language[1].  In the last few years, Bail-In clauses have become common place in financing documentation, although they are only required for documents which are governed by the laws of a non-EEA country and where there is potential liability under that document for an EEA-incorporated credit institution or investment firm and their relevant affiliates, respectively.  Following withdrawal from the EU, the United Kingdom will (subject to any transitional or other agreed arrangements) cease to be a member of the EEA and therefore English law governed contracts containing in-scope liabilities of EU financial institutions may become subject to the requirements of Article 55.  Depending on the status of withdrawal negotiations as we head closer to March 2019, it may be appropriate as a precautionary measure to include Bail-In clauses ahead of time – however, this analysis is very fact specific, and will need to be carefully considered on a case-by-case basis. Governing law and jurisdiction Although EU law is now pervasive throughout the English legal system, English commercial contract law is, for the most part, untouched by EU law and therefore withdrawal from the EU is expected to have little or no impact.  Further, given that EU member states are required to give effect to the parties’ choice of law (regardless of whether that law is the law of an EU member state or another state)[2], the courts of EU member states will continue to give effect to English law in the same way they do currently.  Many loan agreements customarily include ‘one-way’ jurisdiction clauses which limit borrowers/obligors to bringing proceedings in the English courts (rather than having the flexibility to bring proceedings in any court of competent jurisdiction). This allows lenders to benefit from the perceived competency and commerciality of the English courts as regards disputes in the financial sector. Regardless of the outcome of the Brexit negotiations, such clauses  are likely to remain unchanged due to the experience of English judges in handling such disputes and the certainty of the common law system. It is possible that the UK’s withdrawal will impact the extent to which a judgement of the English courts will be enforceable in other EU member states.  Currently, an English judgement is enforceable in all other EU member states pursuant to EU legislation[3].  However, depending on the withdrawal terms agreed with the EU, the heart of this regulation may or may not be preserved. In other words, English judgements could be in the same position to that of, for example, judgements of the New York courts, where enforceability is dependent upon the underlying law of the relevant EU member state; or, an agreement could be reached for automatic recognition of English judgements across EU member states.  In the same vein, the UK’s withdrawal could also impact the enforcement in the UK of judgements of the courts of the remaining EU member states. Conclusion Just six months ahead of the UK’s 29 March 2019 exit date, there remains no agreed legal position as regards the terms of the UK’s withdrawal from the EU. It is clear that, for so long as such impasse remains, the contractual ramifications will continue to be fluid and the subject of discussion.  However, what is apparent is that the financial services sector, and financing arrangements more generally, are heavily impacted and it will be incumbent upon contracting parties, and their lawyers, to consider the relevant terms, consequences and solutions at the appropriate time. [1]   Article 55 of the Bank Resolution and Recovery Directive [2]   Rome I Regulation [3]   Brussels I regulation. Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these issues. Please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s Global Finance practice group, or the authors: Amy Kennedy – London (+44 (0)20 7071 4283, akennedy@gibsondunn.com) Jeffrey L. Steiner – Washington, D.C. (+1 202-887-3632, jsteiner@gibsondunn.com) Alex Hillback – Dubai (+971 (0)4 318 4626, ahillback@gibsondunn.com) Please also feel free to contact the following leaders and members of the Global Finance and Financial Institutions practice groups: Global Finance Group: Thomas M. Budd – London (+44 (0)20 7071 4234, tbudd@gibsondunn.com) Gregory A. Campbell – London (+44 (0)20 7071 4236, gcampbell@gibsondunn.com) Richard Ernest – Dubai (+971 (0)4 318 4639, rernest@gibsondunn.com) Jamie Thomas – Singapore (+65 6507 3609, jthomas@gibsondunn.com) Michael Nicklin – Hong Kong (+852 2214 3809, mnicklin@gibsondunn.com) Linda L. Curtis – Los Angeles (+1 213 229 7582, lcurtis@gibsondunn.com) Aaron F. Adams – New York (+1 212 351 2494, afadams@gibsondunn.com) Financial Institutions Group: Arthur S. Long – New York (+1 212-351-2426, along@gibsondunn.com) Michael D. Bopp – Washington, D.C. (+1 202-955-8256, mbopp@gibsondunn.com) Jeffrey L. Steiner – Washington, D.C. (+1 202-887-3632, jsteiner@gibsondunn.com) Carl E. Kennedy – New York (+1 212-351-3951, ckennedy@gibsondunn.com) © 2018 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

October 1, 2018 |
Gibson Dunn Ranked Among Top New York Real Estate Law Firms

The Real Deal ranked Gibson Dunn No. 2 on its 2018 list of law firms who handled the highest dollar volume of New York real estate sales on the buyer side and also No. 2 on its 2018 list of law firms who handled the highest dollar volume of New York real estate loans on the lender side.  The list was published on October 1, 2018.

September 24, 2018 |
Dodd Frank 2.0: U.S. Federal Banking Agencies Propose New HVCRE Capital Regulations

Click for PDF On September 18, 2018, the Office of the Comptroller of the Currency, Board of Governors of the Federal Reserve System, and Federal Deposit Insurance Corporation (together, the Banking Agencies) proposed revisions to their Basel III capital rules regarding so-called High Volatility Commercial Real Estate (HVCRE) loans.  The purpose of the revisions is to conform the regulatory definition of HVCRE to the changes made by the Economic Growth, Regulatory Relief, and Consumer Protection Act of 2018 (EGRRCPA), which was enacted in May. The proposed regulations generally follow the statutory changes, with certain clarifications, as we discuss below.  The proposal, however, does not address certain interpretive issues that are still outstanding over five years after the original HVCRE regulations were promulgated, although the Banking Agencies do ask in the preamble’s request for comments whether the proposed rule is ambiguous in certain areas and whether “further discussion or interpretation is appropriate.” HVCRE Capital Treatment Under the Original Basel III Capital Rule and the Banking Agencies’ Interpretations HVCRE treatment is a purely American phenomenon; it was not included in the international Basel III framework.  A form of capital “gold plating,” it imposes a 50% heightened capital treatment on certain commercial real estate loans that are characterized as HVCRE exposures. Prior to enactment of the EGRRCPA, the Banking Agencies’ Basel III capital rule defined an HVCRE exposure as follows: A credit facility that, prior to conversion to permanent financing, finances or has financed the acquisition, development, or construction (ADC) of real property, unless the facility finances: One- to four-family residential properties; Certain community development properties The purchase or development of agricultural land, provided that the valuation of the agricultural land is based on its value for agricultural purposes and the valuation does not take into consideration any potential use of the land for non-agricultural commercial development or residential development; or Commercial real estate projects in which: The loan-to-value ratio is less than or equal to the applicable maximum supervisory loan-to-value ratio under Banking Agency standards – e.g., 80% for a commercial construction loan; The borrower has contributed capital to the project in the form of cash or unencumbered readily marketable assets (or has paid development expenses out-of-pocket) of at least 15% of the real estate’s appraised “as completed” value; and The borrower contributed the amount of capital required before the bank advances funds under the credit facility, and the capital contributed by the borrower, or internally generated by the project, is contractually required to remain in the project throughout the life of the project.[1] The original rule provided that the life of a project concluded only when the credit facility was converted to permanent financing or was sold or paid in full.[2] The original Basel III capital rule raised many interpretative questions; few, however, were answered by the Banking Agencies, and others were answered in a non-intuitive, unduly conservative manner.[3]  In particular, the Banking Agencies interpreted the requirement relating to internally generated capital as foreclosing distributions of such capital even if the amount of capital in the project exceeded 15% of “as completed” value post-distribution.[4]  In addition, the Banking Agencies did not permit appreciated land value to be taken into account for purposes of the borrower’s capital contribution. Proposed Regulations – Definition of HVCRE The proposed regulations follow the statute in narrowing the definition of an HVCRE exposure, in particular by requiring that a credit facility have the purpose of improving property into income-producing property.  The proposal defines an HVCRE exposure as: A credit facility secured by land or improved real property that— (A) primarily finances or refinances the acquisition, development, or construction of real property; (B) has the purpose of providing financing to acquire, develop, or improve such real property into income-producing real property; and (C) is dependent upon future income or sales proceeds from, or refinancing of, such real property for the repayment of such credit facility. The proposal interprets this provision as follows.  First, relying on the instructions to bank Call Reports, the proposed regulation defines a “credit facility secured by land or improved real property” as a credit facility where “the estimated value of the real estate collateral at origination (after deducting all senior liens held by others) is greater than 50 percent of the principal amount of the loan at origination.”  Second, the determination of whether the credit facility meets the above HVCRE definition is made once, at the facility’s origination.  Third, the Banking Agencies propose that the HVCRE definition include “other land loans” – generally loans secured by vacant land except land known to be used for agricultural purposes. Proposed Regulations – Exclusions from HVCRE Treatment The statute retained, and in certain important cases, expanded, the exclusions from HVCRE treatment.  The proposed regulations implement these provisions and provide additional definitional interpretation. Certain Commercial Real Estate Projects This exclusion proved the most controversial under the original Basel III treatment, and indeed the Banking Agencies’ conservative approach to the exclusion is likely responsible for the statute’s enactment. Under the proposal, as in the original regulation, the loan-to-value (LTV) ratio for the loan must be less than or equal to the applicable regulatory maximum LTV for the type of property at issue. Next, the borrower must have contributed “capital” of at least 15 percent of the real property’s appraised “as completed” value.  The proposal permits real property (including appreciated land value) to count as capital, along with cash, unencumbered readily marketable assets, and development expenses paid out-of-pocket, that is, “costs incurred by the project and paid by the borrower prior to the advance of funds” by the lending bank.  With respect to the value of contributed real property, the proposal follows the statute and defines it as “the appraised value” under a qualifying appraisal, reduced by the aggregate amount of any other liens on such property.  Notably, the Banking Agencies invite comment on “whether it is appropriate and clear that the cross-collateralization of land in a project would not be included as contributed real property.” The Banking Agencies state that in certain circumstances, such as in the case of purchasing raw land without near-term development plans,” an “as-is” appraisal may be used instead of an “as completed” one, and in certain cases, an evaluation is permissible – for transactions under $500,000 that are not secured by a single one- to four-family residential property and certain other transactions with values less than $400,000. The proposal includes a clarification for what a “project” is for purposes of the “as completed” value and 15 percent capital contribution calculation.  In the case of a project with multiple phases or stages, each phase or stage must have its own appraised “as completed” value, or if applicable, its own evaluation, in order for it to be deemed to be a separate “project.” Finally, the statute overrode the existing regulation by providing that HVCRE status may end prior to the replacement of an ADC loan with permanent financing, upon: the substantial completion of the development or construction of the real property being financed by the credit facility; and cash flow being generated by the real property being sufficient to support the debt service and expenses of the real property, in accordance with the bank’s applicable loan underwriting criteria for permanent financings. The proposed regulations do not further interpret these provisions – and although “substantial completion” is a term of art in the real estate industry, there is still some imprecision as to its exact meaning. One- to Four-Family Residential Properties With respect to the exclusion for one- to four-family residential properties, the proposal defines such properties as properties “containing fewer than five individual dwelling units, including manufactured homes permanently affixed to the underlying property (when deemed to be real property under state law).”  Condominiums and cooperatives would generally not qualify for the exclusion.  However, if the underlying property is a true one- to four-family residential property, the exclusion would cover ADC as well as construction loans, and, in addition, lot development loans.  The exclusion would not cover loans used solely to acquire undeveloped land. Community Development Properties With respect to this exclusion, the proposal refers to the Banking Agencies’ Community Reinvestment Act (CRA) regulations and their definition of community development investment to determine which properties qualify – the “primary purpose” of the applicable loan must be to foster such investment.  These regulations are quite detailed, and therefore a case-by-case analysis of particular properties will be required if the regulations are finalized as proposed. Agricultural Land Relying on bank Call Report Instructions, the Banking Agencies propose a broad definition for this exclusion – “all land known to be used or usable for agricultural purposes.” Existing Income-Producing Properties that Qualify as Permanent Financings Finally, the statute added a new exclusion, for credit facilities for: the acquisition or refinance of existing income-producing real property secured by a mortgage on such property;  and improvements to existing income-producing improved real property secured by a mortgage on such property, in each case, “if the cash flow being generated by the real property is sufficient to support the debt service and expenses of the real property, in accordance with the institution’s applicable loan underwriting criteria for permanent financings.” With respect to this exclusion, the Banking Agencies state only that they “may review the reasonableness of a depository institution’s underwriting criteria for permanent loans” as part of the regular supervisory process. Loans Made Prior to January 1, 2015 Under the statute, loans made prior to January 1, 2015 may not be classified as HVCRE loans.  A 100 percent risk weight may therefore now be applied to any such loans that were previously classified as HVCRE exposures unless a lower risk weight would apply, as long as the loans are not past 90 days or more past due or on nonaccrual. Conclusion With the HVCRE statute and this proposal, the door has closed on the Banking Agencies’ unfortunate prior approach to HVCRE exposures.  The proposed regulations, however, like the ones they replace, do not clearly state their application to the complex structures of real estate transactions, with multiple tranches of financing and different capital instruments, that are common in the market today.  In addition, although it is clear that certain of the 2015 Interagency FAQs are no longer applicable, the proposal does not discuss those FAQs at all – thus missing an opportunity to subject them to the full notice and comment process that the Banking Agencies only recently stated is necessary for agency interpretation to be considered binding law.[5]  It is hoped that the public comment period will provide the Banking Agencies with evidence of the proposal’s ambiguities and that “further discussion and interpretation” of HVCRE treatment in the final regulation is appropriate.    [1]   See, e.g., 12 C.F.R. § 3.2.    [2]   Id.    [3]   The Banking Agencies published certain responses to HVCRE Frequently Asked Questions (Interagency FAQs) in April 2015.    [4]   See Interagency FAQ Response 15.    [5]   See Interagency Statement Clarifying the Scope of Supervisory Guidance, September 11, 2018 (Banking Agencies and the National Credit Union Administration). The following Gibson Dunn lawyers assisted in preparing this client update: Arthur Long and James Springer. Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments.  Please contact any member of the Gibson Dunn team, the Gibson Dunn lawyer with whom you usually work in the firm’s Financial Institutions or Real Estate practice groups, or any of the following: Financial Institutions Group: Arthur S. Long – New York (+1 212-351-2426, along@gibsondunn.com) James O. Springer – Washington, D.C. (+1 202-887-3516, jspringer@gibsondunn.com) Real Estate and Finance Groups: Jesse Sharf – Los Angeles (+1 310-552-8512, jsharf@gibsondunn.com) Erin Rothfuss – San Francisco (+1 415-393-8218, erothfuss@gibsondunn.com) Aaron Beim – New York (+1 212-351-2451, abeim@gibsondunn.com) Linda L. Curtis – Los Angeles (+1 213-229-7582, lcurtis@gibsondunn.com) Drew C. Flowers – Los Angeles (+1 213-229-7885, dflowers@gibsondunn.com) Noam I. Haberman – New York (+1 212-351-2318, nhaberman@gibsondunn.com) Andrew A. Lance – New York (+1 212-351-3871, alance@gibsondunn.com) Victoria Shusterman – New York (+1 212-351-5386, vshusterman@gibsondunn.com) © 2018 Gibson, Dunn & Crutcher LLP Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

July 9, 2018 |
New York State Supreme Court Annuls State Title Insurance Regulations

Click for PDF On July 5, 2018, the Manhattan Supreme Court overturned New York State Insurance Regulation 208. The case involved a challenge by the New York State Land Title Association (NYSLTA) to the New York State Department of Financial Services’ (DFS) recently enacted sweeping regulation (Insurance Regulation 208) that would have barred the entire title insurance industry in New York State from engaging in traditional industry marketing practices ranging from a title insurance agent taking a real estate attorney to lunch to hosting an office party. The regulation also would have imposed an across-the-board, industry-wide 5% rate reduction on title insurance premiums, forbid certain title insurance agents from receiving pick-up fees and gratuities, and capped fees charged by the industry for certain ancillary services at 200% of the cost of the service to the title company. Gibson Dunn represented the industry in bringing an Article 78 action challenging these restrictions as contrary to DFS’s governing statutes, arbitrary and capricious, violations of and due process, among other claims, and challenging the entire regulation as outside the scope of DFS’s authority. Gibson Dunn also argued that Insurance Regulation 208 was economically destructive to the industry, and would lead to small businesses closing and people losing their jobs, and was not justified by any record of misconduct by the industry. After briefing and argument, Justice Rakower of New York State Supreme Court issued a detailed decision (click HERE) finding in NYSLTA’s favor on each of the four specific provisions it was challenging, and then struck down Insurance Regulation 208 in its entirety. The court found that DFS had exceeded the scope of its statutory authority and the Legislature never intended for DFS to prohibit “title insurance corporations from marketing themselves for business – an absurd proposition.” The Court also found the various arguments made by DFS in defense of the regulation to be “irreconcilable and irrational,” and “devoid of economic or other analysis” justifying the restrictions imposed by the agency. Gibson Dunn & Crutcher LLP partner Mylan Denerstein and associates Akiva Shapiro and David Coon represented NYSLTA in this action and are available to answer questions regarding the decision. Please feel free to contact the Gibson Dunn lawyer with whom you usually work, or the following Gibson Dunn team members in New York: Mylan L. Denerstein (+1 212-351-3850, mdenerstein@gibsondunn.com) Akiva Shapiro (+1 212-351-3830, ashapiro@gibsondunn.com) David Coon (+1 212-351-2477, dcoon@gibsondunn.com)

June 28, 2018 |
India – Legal and Regulatory Update (June 2018)

Click for PDF The Indian Market The Indian economy continues to be an attractive investment destination and one of the fastest growing major economies. After a brief period of uncertainty, following the introduction of a uniform goods and services tax and the announcement that certain banknotes would cease to be legal tender, the growth rate of the economy has begun to rebound, increasing to 7.7 percent in the first quarter of 2018, up from 6.3 percent in the previous quarter. In the World Bank’s most recent Ease of Doing Business rankings, India climbed 30 spots to enter the top 100 countries. This update provides a brief overview of certain key legal and regulatory developments in India between May 1, 2017 and June 28, 2018. Key Legal and Regulatory Developments Foreign Investment Compulsory Reporting of Foreign Investment: The Reserve Bank of India (“RBI“) has notified a one-time reporting requirement[1] for Indian entities with foreign investment. Each such entity must report its total foreign investment in a specified format (asking for certain basic information such as the entity’s main business activity) no later than July 12, 2018. Indian entities can submit their reports through RBI’s website. Indian entities that do not comply with this requirement will be considered to be in violation of India’s foreign exchange laws and will not be permitted to receive any additional foreign investment. This one-time filing requirement is a precursor to the implementation of a single master form that aims to integrate current foreign investment reporting requirements by consolidating nine separate forms into one single form. Single Brand Retail: The Government of India (“Government“) has approved up to 100% foreign direct investment (“FDI“) in single brand product retail trading (“SBRT“) under the automatic route (i.e., without prior Government approval), subject to certain conditions.[2] Previously, FDI in SBRT entities exceeding 49% required the approval of the Government. The Government has also relaxed local sourcing conditions attached to such foreign investment. SBRT entities with more than 51% FDI continue to be subject to local sourcing requirements in India, unless the entity is engaged in retail trading of products that have ‘cutting-edge’ technology. All such SBRT entities are required to source 30% of the value of goods purchased from Indian sources. The Government has now relaxed this sourcing requirement by allowing such SBRT entities to count any purchases made for its global operations towards the 30% local sourcing requirement for a period of five years from the year of opening its first store. The Government has clarified that this relaxation is limited to any increment in sourcing from India from the preceding financial year to the current one, measured in Indian Rupees. After this five year period, the threshold must be met directly by the FDI-receiving SBRT entity through its India operations, on an annual basis. Real Estate Broking Service: The Government has clarified that real estate broking service does not qualify as real estate business and is therefore eligible to receive up to 100% FDI under the automatic route.[3] Introduction of the Standard Operating Procedure: In mid-2017 the Government abolished the Foreign Investment Promotion Board – the Government body responsible for rendering decisions on FDI investments requiring Government approval. Instead, in order to streamline regulatory approvals, it has introduced the Standard Operating Procedure for Processing FDI Proposals (“SOP“).[4] The Government has designated certain competent authorities who are to process an application for FDI in the sector assigned to them. For example, the Ministry of Civil Aviation is responsible for considering and approving FDI proposals in the civil aviation sector. Under the SOP, the competent authorities must adhere to time limits within which a decision must be given. Significantly, the SOP mandates a relevant competent authority to obtain the DIPP’s concurrence before it rejects an application or imposes conditions on a proposed investment. Mergers and Acquisitions Relaxation of Merger Notification Timelines: Previously, parties to a transaction, regarded as a combination within the meaning of the [Indian] Competition Act, 2002 were required to notify the Competition Commission of India (“CCI“) within 30 days of a triggering event, such as execution of transaction documents or approval of a merger or amalgamation by the board of directors of the combining parties. Now, the CCI has exempted parties to combinations from the 30 day notice requirement until June 2022.[5] This move will provide parties involved in a combination sufficient time to compile a comprehensive notification and will possibly lead to faster approvals by easing the burden on CCI’s case teams. Rules for Listed Companies Involved in a Scheme: The Securities and Exchange Board of India (“SEBI“)’s listing rules requires listed companies involved in schemes of arrangement under the [Indian] Companies Act, 2013 (“Companies Act“), to file a draft version of the scheme with a stock exchange. This is in order to obtain a no objection/observation letter before the scheme can be filed with the National Company Law Tribunal. In March 2017, SEBI issued a revised framework for schemes proposed by listed companies in India. In January 2018, SEBI issued a circular[6] amending the 2017 framework. As a part of the 2018 amendments, SEBI clarified that a no objection/observation letter is not required to be obtained from a recognized stock exchange for a demerger/hive off of a division of a listed company into a wholly owned subsidiary, or a merger of a wholly owned subsidiary into its parent company. However, draft scheme documents will still need to be filed with the stock exchange for the purpose of information. The stock exchange will then disseminate the information on their website. Companies Act Action Against Non-Compliant Companies: Registrars of companies (“RoC“) in various Indian states, acting on powers granted under the Companies Act, have initiated action against companies which have either not commenced operations or have not been carrying on business in the past two years. In September 2017, the Government announced that over 200,000 companies had been struck-off from the register of companies based on the powers described above.[7] Further, the director identification numbers for individuals serving as directors on the board of such companies were cancelled, resulting in their disqualification to serve on the board of any company for a period of five years. The striking-off was targeted at Indian companies that failed to fulfill regulatory and compliance requirements (such as filing annual returns) for three years.[8] Notification of Layering Rules: The Government has notified a proviso to subsection 87[9] of Section 2 of the Companies Act along with the Companies (Restriction on Number of Layers) Rules, 2017 (the “Layering Rules“).[10] The effect of these notifications is that an Indian company which is not a banking company, non-banking financial company, insurance company or a government company, is not allowed to have more than two layers of subsidiaries. For the purposes of computing the number of layers, Indian companies are not required to take into account one layer consisting of one or more wholly owned subsidiaries. Further, the Layering Rules do not prohibit Indian companies from acquiring companies incorporated outside India which have subsidiaries beyond two layers (as long as such a structure is permitted in accordance with the laws of the relevant country). Provisions of Companies Act Extended to all Foreign Companies: India has enacted the Companies (Amendment) Act, 2017 in order to amend various sections of the Companies Act. The provisions of the amendment act are being brought into effect in a phased manner. Recently, the Government has notified a provision in the Companies (Amendment) Act, 2017[11] which extends the applicability of sections 380 to 386 and sections 392 and 393 of the Companies Act to all foreign companies which have a place of business in India or conduct any business activity in the country. Prior to this amendment, these provisions were only applicable to foreign companies where a minimum of fifty percent of the shares were held by Indian individuals or companies. These provisions of the Companies Act include a requirement to (a) furnish information and documents to the RoC, such as certified copies of constitutional documents, the company’s balance sheet and profit and loss account; and (b) comply with the provisions governing issuance of debentures, preparation of annual returns and maintaining books of account. Notification of Cross Border Merger Rules: The Government had notified Section 234 of the Companies Act and Rule 25A of the Companies (Compromises, Arrangements and Amalgamations) Rules 2016. Please refer to our regulatory update dated May 1, 2017 for further details. In this update, we had referred to the requirement of the RBI’s prior permission in order to commence cross border merger procedures under the Companies Act. On March 20, 2018, the RBI issued the Foreign Exchange Management (Cross Border Merger) Regulations, 2018 (the “Cross Border Merger Rules“).[12] The Cross Border Merger Rules provide for the RBI’s deemed approval where the proposed cross-border merger is in accordance with the parameters specified by it. These parameters include, where the resultant company is an Indian company, a requirement that any borrowings or guarantees transferred to the resultant entity comply with RBI regulations on external commercial borrowings within a period of two years from the effectiveness of the merger. End-use restrictions under the existing RBI regulations do not have to be complied with. However, where the resultant company is an offshore company, the transfer of any borrowings in rupees to the resultant company requires the consent of the Indian lender and must be in compliance with Foreign Exchange Management Act, 1999 and regulations issued thereunder. In addition, repayment of onshore loans will need to be in accordance with the scheme approved by the National Company Law Tribunal. Currently, these provisions apply only to mergers and amalgamations, and not to demergers. Labour Laws States Begin Implementing Model Labour Law: In mid-2016, the Government introduced the Model Shops and Establishments (Regulation of Employment and Conditions of Service) Bill (“S&E Bill“). The S&E Bill, as is the case with other shops and establishments legislation in India, mandates working hours, public holidays and regulates the condition of workers employed in non-industrial establishments such as shops, restaurants and movie theatres. States in India can either adopt the S&E Bill in its entirety, superseding existing regulations, or choose to amend their existing enactments based on the S&E Bill. The S&E Bill seeks to update Indian laws, adapting them to current business requirement for non-industrial establishments. For example, the S&E Bill (a) enables establishments to remain open 365 days in a year, and (b) allows women to work night shifts, while containing provisions for employers to ensure safety of women workers. Registration provisions under the new legislation have also been eased. In late 2017, the State of Maharashtra notified a new shops and establishments statute based on the S&E Bill.  Other states in India are expected to follow suit. Start–ups Issue of Convertible Notes by Start-ups: The Government had eased funding for start-ups in India in January 2016. Please refer to our regulatory update dated May 18, 2016, for an overview of this initiative. In January 2017, the RBI had permitted start-ups to receive foreign investment through the issue of convertible notes.[13] The revised FDI Policy issued in 2017 now incorporates these provisions. The provisions allow for an investment of INR 2,500,000 (approx. USD 36,700) or more to be made in a single tranche. These notes are repayable at the option of the holder, and convertible within a five year period. The issuance of the notes is subject to entry route, sectoral caps, conditions, pricing guidelines and other requirements that are prescribed for the sector by the RBI.[14] Capital Gains Tax Charging of Long Term Capital Gains Tax: An important amendment to Indian tax laws introduced by the Finance Act, 2018[15] is the levy of tax at the rate of 10% on capital gains made on the sale of certain securities (including listed equity shares) held at least for a year. The tax is levied if the total amount of capital gains exceeds INR 100,000 (approx. USD 1,448). This amendment came into effect on April 1, 2018. However, all gains made on existing holdings until January 31, 2018 are exempt from the tax.  In all such ‘grandfathering’ cases, the cost of acquisition of a security is deemed to be the higher of the actual cost of acquisition and the fair market value of the security as on January 31, 2018. Where the consideration received on transfer of the security is lower than the fair market value as on January 31, 2018, the cost of acquisition is deemed to be the higher of the actual cost of acquisition and the consideration received for the transfer.[16] [1] RBI Notification on Reporting in Single Master Form dated June 7, 2018. Available at https://rbidocs.rbi.org.in/rdocs/Notification/PDFs/NT194481067EB1B554402821A8C2AB7A52009.PDF [2] Press Note No. 1 (2018 Series) dated January 23, 2018, Department of Industrial Policy & Promotion, Ministry of Commerce & Industry, Government of India. [3] Id.  [4] Standard Operating Procedure dated June 29, 2017. Available at http://www.fifp.gov.in/Forms/SOP.pdf  [5] MCA Notification dated June 29, 2017. Available at http://www.cci.gov.in/sites/default/files/notification/S.O.%202039%20%28E%29%20-%2029th%20June%202017.pdf  [6] SEBI Circular dated January 3, 2018. Available at https://www.sebi.gov.in/legal/circulars/jan-2018/circular-on-schemes-of-arrangement-by-listed-entities-and-ii-relaxation-under-sub-rule-7-of-rule-19-of-the-securities-contracts-regulation-rules-1957-_37265.html. [7] Press Information Bureau, Government of India, Ministry of Finance, “Department of Financial Services advises all Banks to take immediate steps to put restrictions on bank accounts of over two lakh ‘struck off’ companies”, http://pib.nic.in/newsite/PrintRelease.aspx?relid=170546 (September 5, 2017). [8] Live Mint, “Govt blocks bank accounts of 200,000 dormant firms”, http://www.livemint.com/Companies/oTcu9b66rZQnvFw6mgSCGK/Black-money-Bank-accounts-of-209-lakh-companies-frozen.html (September 6, 2017).  [9] MCA Notification vide S.O. No. 3086(E) dated September 20, 2017.  [10] Notification No. G.S.R. 1176(E) dated September 20, 2017. Available at http://www.mca.gov.in/Ministry/pdf/CompaniesRestrictionOnNumberofLayersRule_22092017.pdf[11] MCA Notification dated February 9, 2018. Available at http://www.mca.gov.in/Ministry/pdf/Commencementnotification_12022018.pdf [12] FEMA Notification dated March 20, 2018. Available at https://rbidocs.rbi.org.in/rdocs/notification/PDFs/CBM28031838E18A1D866A47F8A20201D6518E468E.pdf  [13] RBI Notification of changes to RBI regulations dated January 10, 2017. Available at https://rbi.org.in/scripts/NotificationUser.aspx?Id=10825&Mode=0 [14] Consolidated FDI Policy Circular of 2017. Available at http://dipp.nic.in/sites/default/files/CFPC_2017_FINAL_RELEASED_28.8.17.pdf [15] Section 33 of the Finance Act, 2018. Available at http://egazette.nic.in/writereaddata/2018/184302.pdf [16] CBDT Notification No. F. No. 370149/20/2018-TPL. Available at https://www.incometaxindia.gov.in/news/faq-on-ltcg.pdf Gibson, Dunn & Crutcher lawyers are available to assist in addressing any questions you may have regarding these issues. For further details, please contact the Gibson Dunn lawyer with whom you usually work or the following authors in the firm’s Singapore office: India Team: Jai S. Pathak (+65 6507 3683, jpathak@gibsondunn.com) Karthik Ashwin Thiagarajan (+65 6507 3636, kthiagarajan@gibsondunn.com) Prachi Jhunjhunwala (+65.6507.3645, pjhunjhunwala@gibsondunn.com) © 2018 Gibson, Dunn & Crutcher LLP Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

May 25, 2018 |
Gibson Dunn Receives Chambers USA Excellence Award

At its annual USA Excellence Awards, Chambers and Partners named Gibson Dunn the winner in the Corporate Crime & Government Investigations category. The awards “reflect notable achievements over the past 12 months, including outstanding work, impressive strategic growth and excellence in client service.” This year the firm was also shortlisted in nine other categories: Antitrust, Energy/Projects: Oil & Gas, Energy/Projects: Power (including Renewables), Intellectual Property (including Patent, Copyright & Trademark), Labor & Employment, Real Estate, Securities and Financial Services Regulation and Tax team categories. Debra Wong Yang was also shortlisted in the individual category of Litigation: White Collar Crime & Government Investigations. The awards were presented on May 24, 2018.  

May 24, 2018 |
Dodd Frank 2.0: Reforming U.S. HVCRE Capital Treatment

Click for PDF On Tuesday, May 22, 2018, the U.S. House of Representatives passed the Economic Growth, Regulatory Relief, and Consumer Protection Act (Reform Bill), which had already passed the Senate on a bipartisan basis.  President Trump signed the Reform Bill into law today.  Among the Reform Bill’s more important provisions is a section reforming the current capital treatment of so-called High Volatility Commercial Real Estate (HVCRE) loans.  The Reform Bill, in provisions that are now effective, overrides certain highly conservative provisions in both the federal banking agencies’ (Banking Agencies) Basel III capital rule and their interpretations of it. HVCRE Capital Treatment Under the Basel III Capital Rule and the Banking Agencies’ Interpretations Current HVCRE treatment is a purely American phenomenon; it was not included in the international Basel III framework.  A form of capital “gold plating,” it imposes a 50% heightened capital treatment on certain commercial real estate loans that are characterized as HVCRE loans. The current Basel III capital rule defines an HVCRE loan as follows: A credit facility that, prior to conversion to permanent financing, finances or has financed the acquisition, development, or construction (ADC) of real property, unless the facility finances: One- to four-family residential properties; Certain community development properties The purchase or development of agricultural land, provided that the valuation of the agricultural land is based on its value for agricultural purposes and the valuation does not take into consideration any potential use of the land for non-agricultural commercial development or residential development; or Commercial real estate projects in which: The loan-to-value ratio is less than or equal to the applicable maximum supervisory loan-to-value ratio under Banking Agency standards – e.g., 80% for a commercial construction loan; The borrower has contributed capital to the project in the form of cash or unencumbered readily marketable assets (or has paid development expenses out-of-pocket) of at least 15% of the real estate’s appraised ”as completed” value; and The borrower contributed the amount of capital required  before the bank advances funds under the credit facility, and the capital contributed by the borrower, or internally generated by the project, is contractually required to remain in the project throughout the life of the project.[1] Under the current Basel III capital rule, the life of a project concludes only when the credit facility is converted to permanent financing or is sold or paid in full.[2] The current Basel III capital rule has raised many interpretative questions; however, many of the important ones have not been answered by the Banking Agencies, and others have been answered in a non-intuitive, unduly conservative manner.  In particular, the Banking Agencies interpreted the requirement relating to internally generated capital as foreclosing distributions of such capital even if the amount of capital in the project exceeds 15% of “as completed” value post-distribution.[3]  The Banking Agencies also have not permitted appreciated land value to be taken into account for purposes of the borrower’s capital contribution. The Reform Bill’s Principal Provisions The Reform Bill overrides the current Basel III capital rule.[4]  Specifically, it states that the Banking Agencies may impose a heightened capital charge on an HVCRE loan (as currently defined) only if the loan is also an HVCRE ADC loan.  Such a loan is defined as: A credit facility secured by land or improved real property that, prior to being reclassified by the depository institution as a non-HVCRE ADC loan— (A) primarily finances, has financed, or refinances the acquisition, development, or construction of real property; (B) has the purpose of providing financing to acquire, develop, or improve such real property into income-producing real property; and (C) is dependent upon future income or sales proceeds from, or refinancing of, such real property for the repayment of such credit facility. Thus the loan must not only finance or refinance the acquisition, development, or construction of real property, it must “primarily” do so, must have a development purpose, and must be dependent on future income, sales proceeds or refinancing – not current income.  The “HVCRE ADC” loan definition also corrects some of the unduly conservative regulatory interpretations described above.  It permits appreciated land value, as determined by a qualifying appraisal, to be taken into account for purposes of the 15% test, and it permits capital to be withdrawn as long as the 15% test continues to be met. In addition, the Reform Bill overrides the current Basel III capital rule by stating that HVCRE status may end prior to the replacement of the ADC loan with permanent financing, upon: the substantial completion of the development or construction of the real property being financed by the credit facility; and cash flow being generated by the real property being sufficient to support the debt service and expenses of the real property, in accordance with the bank’s applicable loan underwriting criteria for permanent financings.[5] Additional exemptions from HVCRE treatment apply to loans for: the acquisition or refinance of existing income-producing real property secured by a mortgage on such property, if the cash flow being generated by the real property is sufficient to support the debt service and expenses of the real property, in accordance with the institution’s applicable loan underwriting criteria for permanent financings; and improvements to existing income-producing improved real property secured by a mortgage on such property, if the cash flow being generated by the real property is sufficient to support the debt service and expenses of the real property, in accordance with the institution’s applicable loan underwriting criteria for permanent financings. Finally, loans made prior to January 1, 2015 may not be classified as HVCRE loans. Conclusion The Reform Bill’s HVCRE ADC provisions are a welcome development.  They do not answer every question relating to HVCRE treatment, but they do purge regulatory interpretations that led to heightened capital treatment for many ADC loans in the absence of persuasive risk justifications.  It is to be hoped that the Banking Agencies further the legislation’s intent of aligning gold plated capital treatment more closely to risk when interpreting the new law.    [1]   See, e.g., 12 C.F.R. § 3.2.    [2]   Id.    [3]   See Interagency HVCRE FAQ Response 15.  It remains unclear how this interpretation squares with the text of the HVCRE regulation itself.    [4]   The original version of the Senate bill, which was passed first, did not include this provision.  Senator Tom Cotton, R-Ark, proposed the relevant amendment while the Senate was considering the bill.    [5]   The Reform Bill retains the current exemptions for loans financing one- to four-family residential properties, certain community development properties, and the purchase or development of agricultural land. The following Gibson Dunn lawyers assisted in preparing this client update: Arthur Long and James Springer. Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments.  Please contact any member of the Gibson Dunn team, the Gibson Dunn lawyer with whom you usually work in the firm’s Financial Institutions or Real Estate practice groups, or any of the following: Financial Institutions Group: Arthur S. Long – New York (+1 212-351-2426, along@gibsondunn.com) James O. Springer – Washington, D.C. (+1 202-887-3516, jspringer@gibsondunn.com) Real Estate and Finance Groups: Jesse Sharf – Los Angeles (+1 310-552-8512, jsharf@gibsondunn.com) Eric M. Feuerstein – New York (+1 212-351-2323, efeuerstein@gibsondunn.com) Erin Rothfuss – San Francisco (+1 415-393-8218, erothfuss@gibsondunn.com) Aaron Beim – New York (+1 212-351-2451, abeim@gibsondunn.com) Linda L. Curtis – Los Angeles (+1 213-229-7582, lcurtis@gibsondunn.com) Drew C. Flowers – Los Angeles (+1 213-229-7885, dflowers@gibsondunn.com) Noam I. Haberman – New York (+1 212-351-2318, nhaberman@gibsondunn.com) Victoria Shusterman – New York (+1 212-351-5386, vshusterman@gibsondunn.com) © 2018 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

May 4, 2018 |
Real Estate Finance Partner Kahlil Yearwood Joins Gibson Dunn in San Francisco

Gibson, Dunn & Crutcher LLP is pleased to announce that Kahlil T. Yearwood has joined the firm’s San Francisco office as a partner.  Yearwood, formerly with Dechert LLP, continues his real estate finance practice at Gibson Dunn. “We welcome Kahlil to the firm,” said Ken Doran, Chairman and Managing Partner of Gibson Dunn.  “He is one of the top lender side real estate finance lawyers in the country.  His addition to our San Francisco office will complement the recent growth of our real estate debt capabilities in our New York office and solidify our standing as one of the preeminent real estate practices in the country.” “Our lawyers have frequently been opposite Kahlil on transactions in the past and consider him one of the best lender lawyers in the Bay Area and nationally,” said Erin Rothfuss, a San Francisco partner and Co-Chair of the firm’s Real Estate Practice Group.  “He has a vibrant practice, and his addition will bolster our dominant position in the real estate sector and help create a bicoastal real estate finance platform that is second to none.” “I am delighted to be joining Gibson Dunn,” said Yearwood.  “The firm has an impressive real estate presence on both coasts, and this premiere national platform will give me a strong foundation to grow my practice.” About Kahlil Yearwood Yearwood practices real estate finance with a focus on representing lenders in every phase of the life cycle of loans secured directly or indirectly by all types of commercial real estate, including loan origination, loan purchases, loan sales, financing and leverage transactions, post-closing loan modifications, and loan workouts.  His clients include all types of commercial real estate lenders, including commercial banks, life insurance companies, CMBS lenders, specialty finance companies, debt funds, mortgage REITs, servicers, and hedge funds. He is a Fellow of the American College of Mortgage Attorneys and a member of the Commercial Real Estate Finance Council. Prior to joining the firm, Yearwood practiced with Dechert since 2005.  He received his law degree in 2005 from the University of California, Berkeley.

March 20, 2018 |
Supreme Court Approves Deferential Review of Bankruptcy-Court Determinations on “Insider” Status

Click for PDF On March 5, 2018, the U.S. Supreme Court issued a decision in U.S. Bank N.A. Trustee, By and Through CWCapital Asset Management LLC v. Village at Lakeridge, LLC (No. 15-1509), approving the application of the clear error standard of review in a case determining whether someone was a “non-statutory” insider under the Bankruptcy Code. We note that the Court’s narrow holding only addressed the appropriate standard of review, leaving for another day the question of whether the specific test that the Ninth Circuit used to determine whether the individual was a “non-statutory” insider was correct. The ruling is significant, however, because without the prospect of de novo review, a bankruptcy court’s ruling on whether a person is a “non-statutory” insider will be very difficult to overturn on appeal—which may have significant impact on case outcomes. The Bankruptcy Code “Insider” The Bankruptcy Code’s definition of an insider includes any director, officer, or “person in control” of the entity.[1] This definition is non-exhaustive, so courts have devised tests for identifying other, so-called “non-statutory” insiders, focusing, in whole or in part, on whether a person’s transactions with the debtor were at arm’s length. Background In this case, the debtor (Lakeridge) owed money to two main entities, its sole owner MBP Equity Partners for $2.76 million, and U.S. Bank for $10 million. Lakeridge submitted a plan of reorganization, but it was rejected by U.S. Bank. Lakeridge then turned to the “cramdown” option for imposing a plan impairing the interests of non-consenting creditors. This option requires that at least one impaired class of creditors vote to accept the plan, excluding the votes of all insiders. As the debtor’s sole owner, MBP plainly was an insider of the debtor, within the statutory definition of Bankruptcy Code §101(31)(B)(i)–(iii), so its vote would not count. Therefore, to gain the consent of the MBP voting block to pass the cramdown plan, Kathleen Bartlett (an MPB board member and Lakeridge officer), sold MPB’s claim of $2.76 million to a retired surgeon named Robert Rabkin, for $5,000. Rabkin agreed to buy the debt owed to MBP for $5,000 and proceeded to vote in favor of the proposed plan as a non-insider creditor. U.S. Bank, the other large creditor, objected, arguing that the transaction was a sham and pointing to a pre-existing romantic relationship between Rabkin and Bartlett. If Rabkin were an officer or director of the debtor, Rabkin’s status as an insider would have been undisputed. But because Rabkin had no formal relationship with the debtor, the bankruptcy court had to consider whether the particular relationship was close enough to make him a “non-statutory” insider. The bankruptcy court held an evidentiary hearing and concluded that Rabkin was not an insider, based on its finding that Rabkin and Bartlett negotiated the transaction at arm’s length. Because of this decision, the Debtor was able to confirm a cramdown plan over the objection of the senior secured lender. The Ninth Circuit affirmed the bankruptcy court’s ruling, holding that that the finding was entitled to clear-error review, and therefore would not be reversed. The Supreme Court Holds That the Standard of Review Is Clear Error On certiorari, the Supreme Court, in a unanimous opinion, took pains to emphasize that the sole issue on appeal was the appropriate standard of review, and not any determination of the merits of the “non-statutory” insider test that the Ninth Circuit had applied to determine whether Rabkin was an insider. The Supreme Court held that the Ninth Circuit was correct to review the bankruptcy court’s determination for “clear error” (rather than de novo). The Court discussed the difference between findings of law—which are reviewed de novo—and findings of fact—which are reviewed for clear error. The question in this case—whether Rabkin met the legal test for a non-statutory insider—was a “mixed” question of law and fact. Courts often review mixed questions de novo when they “require courts to expound on the law, particularly by amplifying or elaborating on a broad legal standard.”[2] Conversely, courts use the clearly erroneous standard for mixed questions that “immerse courts in case-specific factual issues.”[3] In sum, the Court explained, “the standard of review for a mixed question all depends on whether answering it entails primarily legal or factual work.”[4] Choosing between those two characterizations, the Court chose the latter. The basic question in this case was whether “[g]iven all the basic facts found, Rabkin’s purchase of MBP’s claim [was] conducted as if the two were strangers to each other.”[5] Because “[t]hat is about as factual sounding as any mixed question gets,”[6] the Court held that the clear error standard applied. The Supreme Court Avoids Adjudicating a Potentially Significant Circuit Split on Tests Used to Determine Non-Statutory Insiders All nine of the justices joined Justice Kagan’s opinion. However, the concurring opinion from Justice Sonia Sotomayor (joined by Justices Anthony Kennedy, Clarence Thomas and Neil Gorsuch) suggests grave doubts about the coherence of the Ninth Circuit’s standard for assessing non-statutory-insider status. Nevertheless, Justice Sotomayor agreed that resolving the propriety of that standard is not a task that warranted the Supreme Court’s attention. Impact of US Bank While this case does not break new ground, it firmly establishes the bankruptcy courts’ authority to make these determinations and limits appellate review. This opinion may embolden appellants (and bankruptcy courts) to push the envelope in the future. Debtors may be emboldened to seek to use a variety of affiliate-transaction structures as they seek the keys to confirming cramdown plans over the objections of senior lenders.    [1]   11 U.S.C. § 101(31)(B)(i)–(iii).    [2]   Decision at p. 8.    [3]   Ibid.    [4]   Id. at p. 2.    [5]   Id. at p. 10.    [6]   Ibid. Gibson, Dunn & Crutcher’s lawyers are available to assist with any questions you may have regarding these issues.  For further information, please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s Business Restructuring and Reorganization practice group, or the following authors: Samuel A.  Newman – Los Angeles (+1 213-229-7644, snewman@gibsondunn.com) Daniel B. Denny – Los Angeles (+1 213-229-7646, ddenny@gibsondunn.com) Sara Ciccolari-Micaldi – Los Angeles (+1 213-229-7887, sciccolarimicaldi@gibsondunn.com) Please also feel free to contact the following practice group leaders: Business Restructuring and Reorganization Group: Michael A. Rosenthal – New York (+1 212-351-3969, mrosenthal@gibsondunn.com) David M. Feldman – New York (+1 212-351-2366, dfeldman@gibsondunn.com) Jeffrey C. Krause – Los Angeles (+1 213-229-7995, jkrause@gibsondunn.com) Robert A. Klyman – Los Angeles (+1 213-229-7562, rklyman@gibsondunn.com) © 2018 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

March 5, 2018 |
Supreme Court Settles Circuit Split Concerning Bankruptcy Code “Safe Harbor”

Click for PDF On February 27, 2018, the U.S. Supreme Court issued a decision in Merit Management Group, LP v. FTI Consulting, Inc. (No. 16-784), settling a circuit split regarding the “safe harbor” provision in § 546(e) of the Bankruptcy Code.  That section bars the avoidance of certain types of securities and commodities transactions that are made by, to or for the benefit of covered entities including financial institutions, stockbrokers and securities clearing agencies. Circuits had split regarding whether the safe harbor protects a transfer that passes through a covered entity, where the entity only acts as a conduit and has no beneficial interest in the property transferred.  In Merit Management, the Court held that the safe harbor does not apply when a covered entity only acts as a conduit, and that the safe harbor only applies when the “relevant transfer” (i.e., the “overarching” transfer sought to be avoided) is by, to or for the benefit of a covered entity.  As a result, the Court held that the safe harbor did not protect a private securities transaction where neither the buyer nor the seller was a covered entity, even though the funds passed through covered entities. The Bankruptcy Code “Safe Harbor” The Bankruptcy Code permits a trustee to bring claims to “avoid” (or undo) for the benefit of the bankruptcy estate certain prepetition transfers or obligations, including claims to avoid a preference (11 U.S.C. § 547) or fraudulent transfer (11 U.S.C. § 548(a)).  Section 546(e) limits those avoidance powers by providing that, “[n]otwithstanding” the trustee’s avoidance powers, “the trustee may not avoid a transfer that is” (1) a “margin payment” or “settlement payment” “made by or to (or for the benefit of)” a covered entity, or (2) “a transfer made by or to (or for the benefit of)” a covered entity “in connection with a securities contract . . . or forward contract.”  11 U.S.C. § 546(e).  The sole exception to the safe harbor is a claim for “actual fraudulent transfer” under § 548(a)(1)(A).  Id. Background Merit Management involved the acquisition of a “racino” (a combined horse racing and casino business) by its competitor.  To consummate the transaction, the buyer’s bank wired $55 million to another bank that acted as a third-party escrow agent, which disbursed the funds to the seller’s shareholders in exchange for their stock in the seller.  The buyer subsequently filed for Chapter 11 bankruptcy protection and a litigation trust was established pursuant to the buyer’s confirmed reorganization plan.  The trustee sued one of the selling shareholders that received $16.5 million from the buyer, alleging that the transaction was a constructive fraudulent transfer under § 548(a)(1)(B) because the buyer was insolvent at the time of the purchase and “significantly overpaid” for the stock. The district court held that the safe harbor barred the fraudulent transfer claim because the transaction was a securities settlement payment involving intermediate transfers “by” and “to” covered entities (the banks).  The Seventh Circuit reversed, holding that the safe harbor did not apply because the banks only acted as conduits and neither the buyer nor the shareholder was a covered entity.  In so holding, the Seventh Circuit diverged from other circuits that had applied the safe harbor to transactions consummated through a covered entity acting as a conduit.[1]  Those circuits interpreted the disjunctive language in the safe harbor that protects transfers “by or to (or for the benefit of)” a covered entity to mean that a transfer “by” or “to” a covered entity is protected even if the transfer is not “for the benefit of” the covered entity.  The Supreme Court granted certiorari to settle the circuit split. The Supreme Court Holds That the Safe Harbor Does Not Protect a Transfer When a Covered Entity Only Acts as a Conduit   The Supreme Court affirmed the Seventh Circuit’s decision, holding that the safe harbor does not protect a transfer when a covered entity only acts as a conduit.  The crux of the decision is that a safe harbor analysis must focus on whether the “relevant transfer,” meaning the “overarching” or “end-to-end” transfer that the trustee seeks to avoid, was by, to or for the benefit of a covered entity.  Whether an intermediate or “component” transfer was made by or to a covered entity is “simply irrelevant to the analysis under § 546(e).”[2]  The Court reasoned that, as an express limitation on the trustee’s avoidance powers, § 546(e) must be applied in relation to the trustee’s exercise of those powers with respect to the transfer that the trustee seeks to avoid, not component transfers that the trustee does not seek to avoid.[3]  In the case before it, because the trustee sought to avoid the “end-to-end” transfer from the buyer to the shareholder, and neither was a covered entity, the safe harbor did not apply. The Court Avoids Adjudicating a Potentially Significant Defense The shareholder did not argue in the lower courts that the buyer or the shareholder was a covered entity.  In its briefing in the Supreme Court, the shareholder argued that the buyer and seller were both covered entities because they were customers of the banks that facilitated the transaction, and the definition of “financial institution” in 11 U.S.C. § 101(22)(A) includes a “customer” of a financial institution when the institution “is acting as agent or custodian for a customer.”  During oral argument, Justice Breyer indicated that he might have been receptive to that potentially dispositive argument.  However, the decision expressly avoids adjudicating the argument on the basis that the shareholder raised the point “only in footnotes and did not argue that it somehow dictates the outcome in this case.”  Id. at n. 2.  As a result, the “customer-as-financial-institution defense” will likely be litigated in the lower courts going forward. Impact of Merit Management As a result of Merit Management, parties to securities and commodities transactions should expect that, in the event of a bankruptcy filing, the safe harbor will not protect a transaction unless the transferor, transferee or beneficiary of the “overarching” transfer is a covered entity.  Routing a transfer through a covered entity will no longer protect the transaction.  Given the increased importance placed on whether a party to the overarching transfer is a covered entity, Merit Management may lead to a new wave of litigation regarding the scope of the covered entities, including the circumstances in which the customer of a financial institution constitutes a covered entity, and related planning strategies to fall within such scope.    [1]   See, e.g., In re Quebecor World (USA) Inc., 719 F. 3d 94, 99 (2d Cir. 2013); In re QSI Holdings, Inc., 571 F. 3d 545, 551 (6th Cir. 2009); Contemporary Indus. Corp. v. Frost, 564 F. 3d 981, 987 (8th Cir. 2009); In re Resorts Int’l, Inc., 181 F. 3d 505, 516 (3d Cir. 1999); In re Kaiser Steel Corp., 952 F. 2d 1230, 1240 (10th Cir. 1991).    [2]   Decision at p. 14.    [3]   See id. at pp. 11-14 (“If a trustee properly identifies an avoidable transfer . . . the court has no reason to examine the relevance of component parts when considering a limit to the avoiding power, where that limit is defined by reference to an otherwise avoidable transfer, as is the case with §546(e). . . .”). Gibson, Dunn & Crutcher’s lawyers are available to assist with any questions you may have regarding these issues.  For further information, please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s Business Restructuring and Reorganization practice group, or the following authors: Oscar Garza – Orange County, CA (+1 949-451-3849, ogarza@gibsondunn.com) Michael A. Rosenthal – New York (+1 212-351-3969, mrosenthal@gibsondunn.com) Douglas G Levin – Orange County, CA (+1 949-451-4196, dlevin@gibsondunn.com) Please also feel free to contact the following practice group leaders: Business Restructuring and Reorganization Group: Michael A. Rosenthal – New York (+1 212-351-3969, mrosenthal@gibsondunn.com) David M. Feldman – New York (+1 212-351-2366, dfeldman@gibsondunn.com) Jeffrey C. Krause – Los Angeles (+1 213-229-7995, jkrause@gibsondunn.com) Robert A. Klyman – Los Angeles (+1 213-229-7562, rklyman@gibsondunn.com) © 2018 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

February 6, 2018 |
New Threat of Substantive Consolidation for Real Estate Lending Structures

Groundbreaking Ninth Circuit Decision Declares Only One Class of Impaired, Consenting Creditors Is Needed to Confirm a Joint Plan Among Multiple Debtors   Click for PDF The Ninth Circuit’s recent opinion in In re Transwest Resort Properties, Inc. is the first circuit-level decision to address whether, under section 1129(a)(10) of the Bankruptcy Code, a multi-debtor joint chapter 11 plan can be “crammed down” with the consent of a single impaired class (the “per plan” interpretation), or whether a class of creditors from each individual debtor entity must consent (“per debtor”).[1] By adopting the per plan approach, Transwest puts creditors on notice that those who stand to lose out from chapter 11 plans that effectively ignore the separateness of related corporate entities—most notably, secured lenders in real estate financings—should be prepared to challenge those schemes as de facto substantive consolidation rather than relying on the voting requirements of section 1129(a)(10) for protection. Before Transwest: Whose Votes Do We Need, Anyway? In 2011, a Delaware bankruptcy court was the first to examine 11 U.S.C. § 1129(a)(10)—which provides that a plan of reorganization may only be confirmed if “at least one class of claims that is impaired under the plan has accepted the plan”—and conclude that this requirement must be met separately for each debtor entity included in a joint plan of reorganization.[2] In In re Tribune Co., Judge Kevin Carey held that a per plan interpretation of section 1129(a)(10) was irreconcilable with the principle that “[i]n the absence of substantive consolidation, entity separateness is fundamental.”[3] Moreover, he observed that a per debtor approach would be consistent with the other provisions of section 1129(a), e.g. the “best interest of creditors” requirement of section 1129(a)(7), which also must be satisfied on a per debtor basis.[4] While the court acknowledged that it might be challenging to obtain debtor-by-debtor consent in a complex case like Tribune, in which two competing joint plans would have reorganized over one hundred affiliated debtors, it concluded that “convenience alone is not sufficient reason to disturb the rights of impaired classes of creditors of a debtor not meeting confirmation standards.” In Tribune, both proposed joint plans contained provisions stating that they were not premised on substantive consolidation, the doctrine which, in certain circumstances, permits chapter 11 plans to treat liabilities of multiple affiliated debtors as liabilities of a single consolidated entity. As Judge Carey observed, such provisions are “not uncommon,” presumably because plan proponents wish to avoid an expensive battle to impose substantive consolidation, proponents of which face a heavy evidentiary burden within bankruptcy courts in the Third Circuit as a result of the circuit-level decision in In re Owens Corning.[5] In the absence of substantive consolidation, the Tribune court concluded that the joint plan in question “actually consists of a separate plan for each Debtor,” and each such plan must separately satisfy the confirmation requirements of section 1129(a).[6] Because several courts had previously held that section 1129(a)(10) could be satisfied on a per plan basis,[7] the decision in Tribune created a split of authority. While one subsequent Delaware case has followed the per debtor approach of Tribune, the Arizona bankruptcy court overseeing the chapter 11 cases of Transwest Resort Properties Inc. and its subsidiaries chose to adopt the per plan interpretation of the statute, setting in motion a string of appeals that led to the Ninth Circuit’s recent precedent-setting decision.[8] The Transwest Chapter 11 Cases Compared to the conglomeration of affiliated debtors in Tribune, the debtors in Transwest were relatively few in number and straightforward in purpose. The underlying assets were two resort hotel properties in Tucson, AZ and Hilton Head, SC, each owned by an operating company (together, the “OpCo Debtors”), and each subject to a single senior mortgage with the OpCo Debtor as the sole obligor.[9] The equity of each OpCo Debtor was 100% owned by a holding company (together, the “Mezzanine Debtors”) each of which incurred additional financing secured by equity in the corresponding OpCo. At the top of the corporate structure was a holding company that owned 100% of the equity of the Mezzanine Debtors. When all five entities filed for chapter 11 bankruptcy in 2010, the owner of the OpCo mortgage debt (the “Lender”) filed proofs of claim against the OpCo Debtors totaling $209 million, while secured claims against the Mezzanine Debtors (claims which the Lender eventually acquired) totaled $39 million. In March 2011, the Lender sought relief from the automatic stay in order to foreclose on its mortgage loans against the OpCo Debtors. The bankruptcy court denied this request, and also denied a June 2011 request to foreclose on the mezzanine debt, paving the way for the five Transwest debtors to propose a joint plan of reorganization (the “Plan”). Under the Plan, a third party would invest $30 million in exchange for the Mezzanine Debtors’ ownership interests in the OpCo Debtors, while the Lender’s senior mortgage debt would be repaid in smaller monthly installment over a longer period.[10] The Lender, which by this time was the also the sole creditor of the Mezzanine Debtors, sought to block confirmation of the plan, arguing, inter alia, that, since section 1129(a)(10) requires the consent of a dissenting class from each debtor, the Plan could not be confirmed without the Lender’s consent. Both the bankruptcy court and, on appeal, the district court concluded that the “per debtor” interpretation of section 1129(a)(10) set forth in Tribune was not persuasive, and that the plain language of the statute supported the per plan approach: The statute states that “[i]f a class of claims is impaired under the plan, at least one class of claims that is impaired under the plan has accepted the plan” then the court shall confirm the plan if additional requirements are met. 11 U.S.C. § 1129(a)(10) (emphasis added). Thus, once an impaired class has accepted the plan, § 1129(a)(10) is satisfied as to all debtors because all debtors are being reorganized under a joint plan of reorganization.[11] With five of ten classes having voted in favor of the joint Plan in Transwest, the lower courts concluded that section 1129(a)(10) was no obstacle to confirmation, notwithstanding the fact that the Lender, the sole creditor of the Mezzanine Debtors, had withheld its consent. The Ninth Circuit’s Decision in Transwest The Lender appealed to the Ninth Circuit, which became the first federal court of appeals to address whether the strictures of section 1129(a)(10) apply on a per debtor basis or per plan basis.[12] The panel of three judges unanimously affirmed the lower courts’ per plan interpretation of the statute. In a succinct opinion, Judge Milan Smith wrote that the plain language of section 1129(a) supported the per plan approach, and that neither the statutory context nor applicable rules of statutory construction altered this reading.[13] Acknowledging the Lender’s concerns that the per plan approach would lead to a “parade of horribles” for similarly situated real estate lenders, the court observed that these were policy concerns best resolved by Congress. Moreover, to the extent that Lenders now argued that the Transwest debtors’ Plan was, in effect, an impermissible substantive consolidation, the court declined to consider this argument since it was raised for the first time on appeal.[14] In a separate concurrence, Judge Friedland wrote to emphasize that she shared some of the Lender’s concerns with respect to substantive consolidation, though she agreed that the Lender waived them by failing to raise them earlier. Judge Friedland observed that, although the Plan provided that the various debtors “technically . . . remained separate,” distributions under the Plan were devised such that “creditors for different Debtors all drew from the same pool of assets.”[15] Given that this kind of de facto substantive consolidation is a common feature of joint plans with multiple related debtors, Judge Friedland emphasized that creditors who believe they lose out from consolidation of the debtors’ assets and liabilities should make their objections promptly and clearly in the bankruptcy courts: [I]f a creditor believes that a reorganization improperly intermingles different estates, the creditor can and should object that the plan—rather than the requirements for confirming the plan—results in de facto substantive consolidation. Such an approach would allow this issue to be assessed on a case-by-case basis, which would be appropriate given the fact-intensive nature of the substantive consolidation inquiry.[16] Conclusion While the Ninth Circuit’s opinion in Transwest provides a measure of comfort for plan proponents with respect to the voting requirements of section 1129(a)(10), it may foreshadow battles to come over de facto substantive consolidation. Moreover, for debtors and creditors in chapter 11 cases outside the Ninth Circuit, it remains to be seen whether bankruptcy courts will follow the per plan approach endorsed in Transwest, or whether the per debtor approach of Tribune will gain new adherents. In the meantime, mezzanine lenders and other creditors whose rights are threatened by multi-debtor plans of reorganization would be well-advised to raise both objections, lest they should find themselves in the unfortunate position of the Lender in Transwest, wondering whether they waived a winning argument. Failure to raise an argument in respect of a chapter 11 plan’s attempt to impermissibly substantively consolidate a multi-debtor estate may frustrate the entire purpose of the senior/mezzanine financing structure, which is to isolate the collateral—and claims—of the senior lender and the mezzanine lender at the appropriate legal entity, and to limit their remedies accordingly. The “per plan” approach, requiring only one impaired accepting class, could result in creditors of a mezzanine debtor determining the treatment of the senior lender’s claim at the opco debtor over the senior lender’s objection.[17] For borrowers and guarantors, the Transwest decision may incentivize parties to file chapter 11 bankruptcy within the Ninth Circuit. Debtors may be able to confirm a plan over the objections of certain creditor groups using the “cram down” mechanism affirmed by the Transwest decision’s interpretation of Section 1129(a)(10).    [1]   In re Transwest Resort Properties, Inc. (JPMCC 2007-C1 Grasslawn Lodging, LLC v. Transwest Resort Properties, Inc.), No. 16-16221, 2018 WL 615431 (9th Cir. Jan. 25, 2018). The Ninth Circuit addressed a second question in Transwest not discussed in this client alert, namely, whether a secured lender’s election to have its entire claim treated as secured under 11 U.S.C. § 1111(b)(2) requires a due-on-sale clause to be included in a debtor’s plan of reorganization. The Ninth Circuit’s opinion, which is marked for publication, is also available for download at http://cdn.ca9.uscourts.gov/datastore/opinions/2018/01/25/16-16221.pdf.    [2]   In re Tribune Co., 464 B.R. 126, 183 (Bankr. D. Del. 2011).    [3]   Id. at 182 (citing In re Owens Corning, 419 F.3d 195, 211 (3d Cir. 2007)).    [4]   Tribune, 464 B.R. at 182.    [5]   In re Owens Corning, 419 F.3d 195, 211–12 (3d Cir. 2007) (“The upshot is this. In our Court what must be proven (absent consent) concerning the entities for whom substantive consolidation is sought is that (i) prepetition they disregarded separateness so significantly their creditors relied on the breakdown of entity borders and treated them as one legal entity, or (ii) postpetition their assets and liabilities are so scrambled that separating them is prohibitive and hurts all creditors. Proponents of substantive consolidation have the burden of showing one or the other rationale for consolidation.”).    [6]   Tribune, 464 B.R. at 182.    [7]   See, e.g., In re SGPA, Inc., 2001 Bankr.LEXIS 2291 (Bankr. M.D. Pa. Sep. 28, 2001); In re Charter Commc’ns, 419 B.R. 221 (Bankr. S.D.N.Y. 2009).    [8]   In re JER/Jameson Mezz Borrower II, LLC, 461 B.R. 293 (Bankr. D. Del. 2011); In re: Transwest Resort Properties, Inc., 554 B.R. 894 (D. Ariz. 2016).    [9]   In re Transwest Resort Properties, Inc., 554 B.R. 894, 896–97 (D. Ariz. 2016). [10]   Id. at 897. [11]   Id. at 901. [12]   The Lender also appealed the lower court’s ruling that Section 1111(b) did not require the inclusion of a due-on-sale clause in the Plan, which the Court affirmed. Accordingly, even though the Lender was entitled to be treated as fully secured under the Plan, the Lender was not entitled to certain covenants and restrictions related to the disposition of its collateral under the terms of the Plan. [13]   In re Transwest Resort Properties, Inc., No. 16-16221, 2018 WL 615431 at *5 (9th Cir. Jan. 25, 2018). (“[T]he Lender provides no support for its position that all subsections [of section 1129(a)] must uniformly apply on a “per debtor” basis.”) [14]   Id. [15]   Id. at *6 (Friedland, J., concurring). [16]   Id. at *8 (citing In re Bonham, 229 F.3d at 765 (“[O]nly through a searching review of the record, on a case-by-case basis, can a court ensure that substantive consolidation effects its sole aim: fairness to all creditors.”)) [17]   The Ninth Circuit’s endorsement of the “per plan” interpretation of section 1129(a)(10) may also prompt renewed attention toward the bankruptcy provisions, including the voting rights with respect to each borrower’s bankruptcy case, in an intercreditor agreement between senior lender and mezzanine lender. Gibson, Dunn & Crutcher’s lawyers are available to assist with any questions you may have regarding these issues.  For further information, please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s Business Restructuring and Reorganization practice group, or the following authors: Matthew K. Kelsey – New York (+1 212-351-2615, mkelsey@gibsondunn.com) Samuel A.  Newman – Los Angeles (+1 213-229-7644, snewman@gibsondunn.com) Daniel B. Denny – Los Angeles (+1 213-229-7646, ddenny@gibsondunn.com) Michael K. Gocksch – Los Angeles (+1 213-229-7076, mgocksch@gibsondunn.com) Please also feel free to contact the following practice group leaders: Business Restructuring and Reorganization Group: Michael A. Rosenthal – New York (+1 212-351-3969, mrosenthal@gibsondunn.com) David M. Feldman – New York (+1 212-351-2366, dfeldman@gibsondunn.com) Jeffrey C. Krause – Los Angeles (+1 213-229-7995, jkrause@gibsondunn.com) Robert A. Klyman – Los Angeles (+1 213-229-7562, rklyman@gibsondunn.com) © 2018 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

January 7, 2018 |
2017 Year-End German Law Update

Click for PDF “May you live in interesting times” goes the old Chinese proverb, which is not meant for a friend but for an enemy. Whoever expressed such wish, interesting times have certainly come to pass for the German economy. Germany is an economic giant focused on the export of its sophisticated manufactured goods to the world’s leading markets, but it is also, in some ways, a military dwarf in a third-tier role in the re-sketching of the new world order. Germany’s globally admired engineering know-how and reputation has been severely damaged by the Volkswagen scandal and is structurally challenged by disruptive technologies and regulatory changes that may be calling for the end of the era of internal combustion engines. The top item on Germany’s foreign policy agenda, the further integration of the EU-member states into a powerful economic and political union, has for some years now given rise to daily crisis management, first caused by the financial crisis and, since last year, by the uncertainties of BREXIT. As if this was not enough, internal politics is still handling the social integration of more than a million refugees that entered the country in 2015, who rightly expect fair and just treatment, education, medical care and a future. It has been best practice to address such manifold issues with a strong and hands-on government, but – unfortunately – this is also currently missing. While the acting government is doing its best to handle the day-to-day tasks, one should not expect any bold move or strategic initiative before a stable, yet to be negotiated parliamentary coalition majority has installed new leadership, likely again under Angela Merkel. All that will drag well into 2018 and will not make life any easier. In stark contrast to the difficult situation the EU is facing in light of BREXIT, the single most impacting piece of regulation that will come into effect in May 2018 will be a European Regulation, the General Data Protection Regulation, which will harmonize data protection law across the EU and start a new era of data protection. Because of its broad scope and its extensive extraterritorial reach, combined with onerous penalties for non-compliance, it will open a new chapter in the way companies world-wide have to treat and process personal data. In all other areas of the law, we observe the continuation of a drive towards ever more transparency, whether through the introduction of new transparency registers disclosing relevant ultimate beneficial owner information or misconduct, through obligatory disclosure regimes (in the field of tax law), or through the automatic exchange under the OECD’s Common Reporting Standard of Information that hitherto fell under the protection of bank secrecy laws. While all these initiatives are well intentioned, they present formidable challenges for companies to comply with the increased complexity and adequately respond to the increased availability and flow of sensitive information. Even more powerful than the regulatory push is the combination of cyber-attacks, investigative journalism, and social media: within a heartbeat, companies or individuals may find themselves exposed on a global scale to severe allegations or fundamental challenges to the way they did or do business. While this trend is not of a legal nature, but a consequence of how we now communicate and whom we trust (or distrust), for those affected it may have immediate legal implications that are often highly complex and difficult to control and deal with. Interesting times usually are good times for lawyers that are determined to solve problems and tackle issues. This is what we love doing and what Gibson Dunn has done best time and again in the last 125 years. We therefore remain optimistic, even in view of the rough waters ahead which we and our clients will have to navigate. We want to thank you for your trust in our services in Germany and your business that we enjoy here and world-wide. We do hope that you will gain valuable insights from our Year-End Alert of legal developments in Germany that will help you to successfully focus and resource your projects and investments in Germany in 2018 and beyond; and we promise to be at your side if you need a partner to help you with sound and hands-on legal advice for your business in and with Germany or to help manage challenging or forward looking issues in the upcoming exciting times. ________________________________ Table of Contents 1.  Corporate, M&A 2.  Tax 3.  Financing and Restructuring 4.  Labor and Employment 5.  Real Estate 6.  Data Protection 7.  Compliance 8.  Antitrust and Merger Control ________________________________ 1. Corporate, M&A 1.1       Corporate, M&A – Transparency Register – New Transparency Obligations on Beneficial Ownership As part of the implementation of the 4th European Money Laundering Directive into German law, Germany has created a new central electronic register for information about the beneficial owners of legal persons organized under German private law as well as registered partnerships incorporated within Germany. Under the restated German Money Laundering Act (Geldwäschegesetz – GWG) which took effect on June 26, 2017, legal persons of German private law (e.g. capital corporations like stock corporations (AG) or limited liability companies (GmbH), registered associations (eingetragener Verein – e.V.), incorporated foundations (rechtsfähige Stiftungen)) and all registered partnerships (e.g. offene Handelsgesellschaft (OHG), Kommanditgesellschaft (KG) and GmbH & Co. KG) are now obliged to “obtain, keep on record and keep up to date” certain information about their “beneficial owners” (namely: first and last name, date of birth, place of residence and details of the beneficial interest) and to file the respective information with the transparency register without undue delay (section 20 (1) GWG). A “beneficial owner“ in this sense is a natural person who directly or indirectly holds or controls more than 25% of the capital or voting rights, or exercises control in a similar way (section 3 (2) GWG). Special rules apply for registered associations, trusts, non-charitable unregulated associations and similar legal arrangements. “Obtaining” the information does not require the entities to carry out extensive investigations, potentially through multi-national and multi-level chains of companies. It suffices to diligently review the information on record and to have in place appropriate internal structures to enable it to make a required filing without undue delay. The duty to keep the information up to date generally requires that the company checks at least on an annual basis whether there have been any changes in their beneficial owners and files an update, if necessary. A filing to the transparency register, however, is not required if the relevant information on the beneficial owner(s) is already contained in certain electronic registers (e.g. the commercial register or the so-called “Unternehmensregister“). This exemption only applies if all relevant data about the beneficial owners is included in the respective documents and the respective registers are still up to date. This essentially requires the obliged entities to diligently review the information available in the respective electronic registers. Furthermore, as a matter of principle, companies listed on a regulated market in the European Union (“EU“) or the European Economic Area (“EEA“) (excluding listings on unregulated markets such as e.g. the Entry Standard of the Frankfurt Stock Exchange) or on a stock exchange with equivalent transparency obligations with respect to voting rights are never required to make any filings to the transparency register. In order to enable the relevant entity to comply with its obligations, shareholders who qualify as beneficial owners or who are directly controlled by a beneficial owner, irrespective of their place of residence, must provide the relevant entity with the relevant information. If a direct shareholder is only indirectly controlled by a beneficial owner, the beneficial owner himself (and not the direct shareholder) must inform the company and provide it with the necessary information (section 20 (3) sentence 4 GWG). Non-compliance with these filing and information obligations may result in administrative fines of up to EUR 100,000. Serious, repeated or systematic breaches may even trigger sanctions up to the higher fine threshold of EUR 1 million or twice the economic benefit of the breach. The information submitted to the transparency register is not generally freely accessible. There are staggered access rights with only certain public authorities, including the Financial Intelligence Unit, law enforcement and tax authorities, having full access rights. Persons subject to know-your-customer (“KYC“) obligations under the Money Laundering Act such as e.g. financial institutions are only given access to the extent the information is required for them to fulfil their own KYC obligations. Other persons or the general public may only gain access if they can demonstrate a legitimate interest in such information. Going forward, every entity subject to the Money Laundering Act should verify whether it is beneficially owned within the aforementioned sense, and, if so, make the respective filing to the transparency register unless the relevant information is already contained in a public electronic register. Furthermore, relevant entities should check (at least) annually whether the information on their beneficial owner(s) as filed with the transparency or other public register is still correct. Also, appropriate internal procedures need to be set up to ensure that any relevant information is received by a person in charge of making filings to the registers. Back to Top 1.2       Corporate, M&A – New CSR Disclosure Obligations for German Public Interest Companies  Effective for fiscal years commencing on or after January 1, 2017, large companies with more than 500 employees are required to include certain non-financial information regarding their management of social and environmental challenges in their annual reporting (“CSR Information“). The new corporate social responsibility reporting rules (“CSR Reporting Rules“) implement the European CSR Directive into German law and are intended to help investors, consumers, policy makers and other stakeholders to evaluate the non-financial performance of large companies and encourage companies to develop a responsible and sustainable approach to business. The CSR Reporting Rules apply to companies with a balance sheet sum in excess of EUR 20 million and an annual turnover in excess of EUR 40 million, whose securities (stock or bonds etc.) are listed on a regulated market in the EU or the EEA as well as large banks and large insurance companies. It is estimated that approximately 550 companies in Germany are covered. Exemptions apply to consolidated subsidiaries if the parent company publishes the CSR Information in the group reporting. The CSR Reporting Rules require the relevant companies to inform on the policies they implemented, the results of such policies and the business risks in relation to (i) environmental protection, (ii) treatment of employees, (iii) social responsibility, (iv) respect for human rights and (v) anti-corruption and bribery. In addition, listed stock corporations are also obliged to inform with regard to diversity on their company boards. If a company has not implemented any such policy, an explicit and justified disclosure is required (“comply or explain”). Companies must further include significant non-financial performance indicators and must also include information on the amounts reported in this respect in their financial statements. The CSR Information can either be included in the annual report or by way of a separate CSR report, to be published on the company’s website or together with its regular annual report with the German Federal Gazette (Bundesanzeiger). The CSR Reporting Rules will certainly increase the administrative burden placed on companies when preparing their annual reporting documentation. It remains to be seen if the new rules will actually meet the expectations of the European legislator and foster and create a more sustainable approach of large companies to doing business in the future . Back to Top 1.3       Corporate, M&A – Corporate Governance Code Refines Standards for Compliance, Transparency and Supervisory Board Composition Since its first publication in 2002, the German Corporate Governance Code (Deutscher Corporate Governance Kodex – DCGK) which contains standards for good and responsible governance for German listed companies, has been revised nearly annually. Even though the DCGK contains only soft law (“comply or explain”) framed in the form of recommendations and suggestions, its regular updates can serve as barometer for trends in the public discussion and sometimes are also a forerunner for more binding legislative measures in the near future. The main changes in the most recent revision of the DCGK in February 2017 deal with aspects of compliance, transparency and supervisory board composition. Compliance The general concept of “compliance” was introduced by the DCGK in 2007. In this respect, the recent revision of the DCGK brought along two noteworthy new aspects. On the one hand, the DCGK now stresses in its preamble that good governance and management does not only require compliance with the law and internal policies but also ethically sound and responsive behavior (the “reputable businessperson concept”). On the other hand, the DCGK now recommends the introduction of a compliance management system (“CMS“). In keeping with the common principle of individually tailored compliance management systems that take into account the company’s specific risk situation, the DCGK now recommends appropriate measures reflecting the company’s risk situation and disclosing the main features of the CMS publically, thus enabling investors to make an informed decision on whether the CMS meets their expectations. It is further expressly recommended to provide employees with the opportunity to blow the whistle and also suggested to open up such whistle-blowing programs to third parties. Supervisory Board In line with the ongoing international trend of focusing on supervisory board composition, the DCGK now also recommends that the supervisory board not only should determine concrete objectives for its composition, but also develop a tailored skills and expertise profile for the entire board and to disclose in the corporate governance report to which extent such benchmarks and targets have been implemented in practice. In addition, the significance of having sufficient independent members on the supervisory board is emphasized by a new recommendation pursuant to which the supervisory board should disclose the appropriate number of independent supervisory board members as well as the members which meet the “independence” criteria in the corporate governance report. In accordance with international best practice, it is now also recommended to provide CVs for candidates for the supervisory board including inter alia relevant knowledge, skills and experience and to publish this information on the company’s website. With regard to supervisory board transparency, the DCGK now also recommends that the chairman of the supervisory board should be prepared, within an appropriate framework, to discuss topics relevant to the supervisory board with investors (please see in this regard our 2016-Year-End Alert, section 1.2). These new 2017 recommendations further highlight the significance of compliance and the role of the supervisory board not only for legislators but also for investors and other stakeholders. As soon as the annual declarations of non-conformity (“comply or explain”) are published over the coming weeks and months, it will be possible to assess how well these new recommendations will be received as well as what responses there will be to the planned additional supervisory board transparency (including, in particular, by family-controlled companies with employee co-determination on the supervisory board). Back to Top 1.4       Corporate, M&A – Employee Co-Determination: No European Extension As set out in greater detail in past alerts (please see in this regard our 2016 Year-End Alert, section 1.3 with further references), the scope and geographic reach of the German co-determination rules (as set out in the German Co-Determination Act; Mitbestimmungsgesetz – MitbestG and in the One-Third-Participation Act; Drittelbeteiligungsgesetz – DrittelbG) were the subject of several ongoing court cases. This discussion has been put to rest in 2017 by a decision of the European Court of Justice (ECJ, C-566/15 – July 18, 2017) that held that German co-determination rules and their restriction to German-based employees as the numeric basis for the relevant employee thresholds and as populace entitled to vote for such co-determined supervisory boards do not infringe against EU law principles of anti-discrimination and freedom of movement. The judgment has been received positively by both German trade unions and corporate players because it preserves the existing German co-determination regime and its traditional, local values against what many commentators would have perceived to be an undue pan-Europeanization of the thresholds and the right to vote for such bodies. In particular, the judgment averts the risk that many supervisory boards would have had to be re-elected based on a pan-European rather than solely German employee base. Back to Top 1.5       Corporate, M&A – Germany Tightens Rules on Foreign Takeovers On July 18, 2017, the amended provisions on foreign direct investments under the Foreign Trade and Payments Ordinance (Außenwirtschaftsverordnung – AWV), expanding and specifying the right of the Federal Ministry for Economic Affairs and Energy (“Ministry“) to review whether the takeover of domestic companies by investors outside the EU or the European Free Trade Area poses a danger to the public order or security of the Federal Republic of Germany came into force. The amendment has the following five main effects which will have a considerable impact on the M&A practice: (i) (non-exclusive) standard categories of companies and industries which are relevant to the public order or security for cross-sector review are introduced, (ii) the stricter sector-specific rules for industries of essential security interest (such as defense and IT-security) are expanded and specified, (iii) there is a reporting requirement for all takeovers within the relevant categories, (iv) the time periods for the review process are extended, and (v) there are stricter and more specific restrictions to prevent possible circumventions. Under the new rules, a special review by the German government is possible in cases of foreign takeovers of domestic companies which operate particularly in the following sectors: (i) critical infrastructure amenities, such as the energy, IT and telecommunications, transport, health, water, food and finance/insurance sectors (to the extent they are very important for the functioning of the community), (ii) sector-specific software for the operation of these critical infrastructure amenities, (iii) telecom carriers and surveillance technology and equipment, (iv) cloud computing services and (v) telematics services and components. The stricter sector-specific rules for foreign takeovers within the defense and IT-security industry are also expanded and now also apply to the manufacturers of defense equipment for reconnaissance and support. Furthermore, the reporting requirement no longer applies only to transactions within the defense and IT-security sectors, but also to all foreign takeovers that fall within the newly introduced cross-sector standard categories described above. The time periods allowed for the Ministry to intervene have been extended throughout. In particular, if an application for a clearance certificate is filed, the clearance certificate will be deemed granted in the absence of a formal review two months following receipt of the application rather than one month as in the past, and the review periods are suspended if the Ministry conducts negotiations with the parties involved. Further, a review may be commenced until five years after the signing of the purchase agreement, which in practice will likely result in an increase of applications for a clearance certificate in order to obtain more transaction certainty. Finally, the new rules provide for stricter and more specific restrictions of possible circumventions by, for example, the use of so-called “front companies” domiciled in the EU or the European Free Trade Area and will trigger the Ministry’s right to review if there are indications that an improper structuring or evasive transaction was at least partly chosen to circumvent the review by the Ministry. Although the scope of the German government’s ability to intervene in M&A processes has been expanded where critical industries are concerned, it is not clear yet to what extent stronger interference or more prohibitions or restrictions will actually occur in practice. And even though the new law provides further guidance, there are still areas of legal uncertainty which can have an impact on valuations and third party financing unless a clearance certificate is obtained. Due to the suspension of the review period in the case of negotiations with the Ministry, the review procedure has, at least in theory, no firm time limit. As a result, the M&A advisory practice has to be prepared for a more time-consuming and onerous process for transactions in the critical industries and may thus be forced to allow for more time between signing and closing. In addition, appropriate termination clauses (and possibly break fees) must be considered for purposes of the share purchase agreement in case a prohibition or restriction of the transaction on the basis of the amended AWV cannot be excluded. Back to Top 2. Tax 2.1       Tax – Unconstitutionality of German Change-of-Control Rules Tax loss carry forwards are an important asset in every M&A transaction. Over the past ten years the German change-of-control rules, which limit the use of losses and loss carry forwards (“Losses“) of a German target company, have undergone fundamental legislative changes. The current change-of-control rules may now face another significant revision as – according to the German Federal Constitutional Court (Bundesverfassungsgericht – BVerfG) and the Lower Tax Court of Hamburg – the current tax regime of the change-of-control rules violates the constitution. Under the current change-of-control rules, Losses of a German corporation will be forfeited on a pro rata basis if within a period of five years more than 25% but not more than 50% of the shares in the German loss-making corporation are transferred (directly or indirectly) to a new shareholder or group of shareholders with aligned interests. If more than 50% are transferred, Losses will be forfeited in total. There are exceptions to this rule for certain intragroup restructurings, built-in gains and – since 2016 – for business continuations, especially in the venture capital industry. On March 29, 2017, the German Federal Constitutional Court ruled that the pro rata forfeiture of Losses (share transfer of more than 25% but not more than 50%) is not in line with the constitution. The BVerfG held that the provision leads to unequal treatment of companies. The aim of avoiding legal but undesired tax optimizations does not justify the broad and general scope of the provision. The BVerfG has asked the German legislator to amend the change-of-control rules retroactively for the period from January 1, 2008 until December 31, 2015 and bring them in line with the constitution. The legislative changes need to be finalized by December 31, 2018. Furthermore, in another case on August 29, 2017, the Lower Tax Court of Hamburg held that the change-of-control rules, which result in a full forfeiture of Losses after a transfer of more than 50% of the shares in a German corporation, are also incompatible with the constitution. The ruling is based on the 2008 wording of the change-of-control rules but the wording of these rules is similar to that of the current forfeiture rules. In view of the March 2017 ruling of the Federal Constitutional Court on the pro-rata forfeiture, the Lower Tax Court referred this case also to the Federal Constitutional Court to rule on this issue as well. If the Federal Constitutional Court decides in favor of the taxpayer the German tax legislator may completely revise the current tax loss limitation regime and limit its scope to, for example, abusive cases. A decision by the Federal Constitutional Court is expected in the course of 2018. Affected market participants are therefore well advised to closely monitor further developments and consider the impact of potential changes on past and future M&A deals with German entities. Appeals against tax assessments should be filed and stays of proceedings applied for by reference to the case before the Federal Constitutional Court in order to benefit from a potential retroactive amendment of the change-of-control rules. Back to Top 2.2       Tax – New German Tax Disclosure Rules for Tax Planning Schemes In light of the Panama and Paradise leaks, the respective Finance Ministers of the German federal states (Bundesländer) created a working group in November 2017 to establish how the new EU Disclosure Rules for advisers and taxpayers as published by the European Commission (“Commission“) on July 25, 2017 can be implemented into German law. Within the member states of the EU, mandatory tax disclosure rules for tax planning schemes already exist in the UK, Ireland and Portugal. Under the new EU disclosure rules certain tax planners and advisers (intermediaries) or certain tax payers themselves must disclose potentially aggressive cross-border tax planning arrangements to the tax authorities in their jurisdiction. This new requirement is a result of the disclosure rules as proposed by the OECD in its Base Erosion and Profit Shifting (BEPS) Action 12 report, among others. The proposal requires tax authorities in the EU to automatically exchange reported information with other tax authorities in the EU. Pursuant to the Commission’s proposal, an “intermediary” is the party responsible for designing, marketing, organizing or managing the implementation of a tax payer´s reportable cross border arrangement, while also providing that taxpayer with tax related services. If there is no intermediary, the proposal requires the taxpayer to report the arrangement directly. This is, for example, the case if the taxpayer designs and implements an arrangement in-house, if the intermediary in question does not have a presence within the EU or in case the intermediary cannot disclose the information because of legal professional privilege. The proposal does not define what “arrangement” or “aggressive” tax planning means but lists characteristics (so-called “hallmarks“) of cross-border tax planning schemes that would strongly indicate whether tax avoidance or abuse occurred. These hallmarks can either be generic or specific. Generic hallmarks include arrangements where the tax payer has complied with a confidentiality provision not to disclose how the arrangement could secure a tax advantage or where the intermediary is entitled to receive a fee with reference to the amount of the tax advantage derived from the arrangement. Specific hallmarks include arrangements that create hybrid mismatches or involve deductible cross border payments between related parties with a preferential tax regime in the recipient’s tax resident jurisdiction. The information to be exchanged includes the identities of the tax payer and the intermediary, details about the hallmarks, the date of the arrangement, the value of the transactions and the EU member states involved. The implementation of such mandatory disclosure rules on tax planning schemes are heavily discussed in Germany especially among the respective bar associations. Elements of the Commission’s proposal are regarded as a disproportionate burden for intermediaries and taxpayers in relation to the objective. Further clarity is needed to align the proposal with the general principle of legal certainty. Certain elements of the proposal may contravene EU law or even the German constitution. And the interaction with the duty of professional secrecy for lawyers and tax advisors is also still unclear. Major efforts are therefore needed for the German legislator to make such a disclosure regime workable both for taxpayers/intermediaries and the tax administrations. It remains to be seen how the Commission proposal will be implemented into German law in 2018 and how tax structuring will be affected. Back to Top 2.3       Tax – Voluntary Self-Disclosure to German Tax Authorities Becomes More Challenging German tax law allows voluntary self-disclosure to correct or supplement an incorrect or incomplete tax return. Valid self-disclosure precludes criminal liability for tax evasion. Such exemption from criminal prosecution, however, does not apply if the tax evasion has already been “detected” at the time of the self-disclosure and this is at least foreseeable for the tax payer. On May 5, 2017 the German Federal Supreme Court (Bundesgerichtshof – BGH) further specified the criteria for voluntary self-disclosure to secure an exemption from criminal prosecution (BGH, 1 StR 265/16 – May 9, 2017). The BGH ruled that exemption from criminal liability might not apply if a foreign authority had already discovered the non- or underreported tax amounts prior to such self-disclosure. Underlying the decision of the BGH was the case of a German employee of a German defense company, who had received payments from a Greek business partner, but declared neither the received payments nor the resulting income in his tax declaration. The payment was a reward for his contribution in selling weapons to the Greek government. The Greek authorities learned of the payment to the German employee early in 2004 in the course of an anti-bribery investigation and obtained account statements proving the payment through intermediary companies and foreign banks. On January 6, 2014, the German employee filed a voluntary self-disclosure to the German tax authorities declaring the previously omitted payments. The respective German tax authority found that this self-disclosure was not submitted in time to exempt the employee from criminal liability. The issue in this case was by whom and at what moment in time the tax evasion needed to be detected in order to render self-disclosure invalid. The BGH ruled that the voluntary self-disclosure by the German employee was futile due to the fact that the payment at issue had already been detected by the Greek authorities at the time of the self-disclosure. In this context, the BGH emphasized that it was not necessary for the competent tax authorities to have detected the tax evasion, but it was sufficient if any other authority was aware of the tax evasion. The BGH made clear that this included foreign authorities. Thus, a prior detection is relevant if on the basis of a preliminary assessment of the facts a conviction is ultimately likely to occur. This requirement is for example met if it can be expected that the foreign authority that detected the incorrect, incomplete or omitted fact will forward this information to the German tax authorities as in the case before the BGH. In particular, there was an international assistance procedure in place between German and Greek tax authorities and the way the payments were made by using intermediaries and foreign banks made it obvious to the Greek authorities that the relevant amounts had not been declared in Germany. Due to the media coverage of the case, this was also at least foreseeable for the German employee. This case is yet another cautionary tale for tax payers not to underestimate the effects of increased international cooperation of tax authorities. Back to Top 3. Financing and Restructuring 3.1       Financing and Restructuring – Upfront Banking Fees Held Void by German Federal Supreme Court On July 4, 2017, the German Federal Supreme Court (Bundesgerichtshof – BGH) handed down two important rulings on the permissibility of upfront banking fees in German law governed loan agreements. According to the BGH, boilerplate clauses imposing handling, processing or arrangement fees on borrowers are void if included in standard terms and conditions (Allgemeine Geschäftsbedingungen). With this case, the court extended its prior rulings on consumer loans to commercial loans. The BGH argued that clauses imposing a bank’s upfront fee on a borrower fundamentally contradict the German statutory law concept that the consideration for granting a loan is the payment of interest. If ancillary pricing arrangements (Preisnebenabreden) pass further costs and expenses on to the borrower, the borrower is unreasonably disadvantaged by the user (Verwender) of standard business terms, unless the additional consideration is agreed for specific services that go beyond the mere granting of the loan and the handling, processing or arrangement thereof. In the cases at hand, the borrowers were thus awarded repayment of the relevant fee. The implications of these rulings for the German loan market are far-reaching. The rulings affect all types of upfront fees for a lender’s services which are routinely passed on to borrowers even though they would otherwise be owed by the lender pursuant to statutory law, a regulatory regime or under a contract or which are conducted in the lender’s own interest. Consequently, this covers fees imposed on the borrower for the risk assessment (Bonitätsprüfung), the valuation of collateral, expenses for the collection of information on the assessment of a borrower’s financing requirements and the like. At this stage, it is not yet certain if, for example, agency fees or syndication fees could also be covered by the decision. There are, however, good arguments to reason that services rendered in connection with a syndication are not otherwise legally or contractually owed by a lender. Upfront fees paid in the past, i.e. in 2015 or later, can be reclaimed by borrowers. The BGH applied the general statutory three year limitation period and argued that the limitation period commenced at the end of 2011 after Higher District Courts (Oberlandesgerichte) had held upfront banking fees void in deviation from previous rulings. As of such time, borrowers should have been aware that a repayment claim of such fees was possible and could have filed a court action even though the enforcement of the repayment was not risk-free. Going forward, it can be expected that lenders will need to modify their approach as a result of the rulings: Choosing a foreign (i.e. non-German) law for a separate fee agreement could be an option for lenders, at least, if either the lender or the borrower is domiciled in the relevant jurisdiction or if there is a certain other connection to the jurisdiction of the chosen law. If the loan is granted by a German lender to a German borrower, the choice of foreign law would also be generally recognized, but under EU conflict of law provisions mandatory domestic law (such as the German law on standard terms) would likely still continue to apply. In response to the ruling, lenders are also currently considering alternative fee structures: Firstly, the relevant costs and expenses underlying such fees are being factored into the calculation of the interest and the borrower is then given the option to choose an upfront fee or a (higher) margin. This may, however, not always turn out to be practical, in particular given that a loan may be refinanced prior to generating the equivalent interest income. Secondly, a fee could be agreed in a separate fee letter which specifically sets out services which go beyond the typical services a bank renders in its own interest. It may, however be difficult to determine services which actually justify a fee. Finally, a lender might charge typical upfront fees following genuine individual negotiations. This requires that the lender not only shows that it was willing to negotiate the amount of the relevant fee, but also that it was generally willing to forego the typical upfront fee entirely. However, if the borrower rejects the upfront fee, the lender still needs to rely on alternative fee arrangements. Further elaboration by the courts and market practice should be closely monitored by lenders and borrowers alike. Back to Top 3.2       Financing and Restructuring – Lingering Uncertainty about Tax Relief for Restructuring Profits Ever since the German Federal Ministry of Finance issued an administrative order in 2003 (“Restructuring Order“) the restructuring of distressed companies has benefited from tax relief for income tax on “restructuring profits”. In Germany, restructuring profits arise as a consequence of debt to equity swaps or debt waivers with regard to the portion of such debt that is unsustainable. Debtors and creditors typically ensured the application of the Restructuring Order by way of a binding advance tax ruling by the tax authorities thus providing for legal certainty in distressed debt scenarios for the parties involved. However, in November 2016, the German Federal Tax Court (Bundesfinanzhof – BFH) put an end to such preferential treatment of restructuring profits. The BFH held the Restructuring Order to be void arguing that the Federal Ministry of Finance had lacked the authority to issue the Restructuring Order. It held that such a measure would need to be adopted by the German legislator instead. The Ministry of Finance and the German restructuring market reacted with concern. As an immediate response to the ruling the Ministry of Finance issued a further order on April 27, 2017 (“Continuation Order”) to the effect that the Restructuring Order continued to apply in all cases in which creditors finally and with binding effect waived claims on or before February 8, 2017 (the date on which the ruling of the Federal Tax Court was published). But the battle continued. In August 2017, the Federal Tax Court also set aside this order for lack of authority by the Federal Ministry of Finance. In the meantime, the German Bundestag and the Bundesrat have passed legislation on tax relief for restructuring profits, but the German tax relief legislation will only enter into force once the European Commission issues a certificate of non-objection confirming the new German statutory tax relief’s compliance with EU restrictions on state aid. This leaves uncertainty as to whether the new law will enter into force in its current wording and when. Also, the new legislation will only cover debt waivers/restructuring profits arising after February 8, 2017 but at this stage does not provide for the treatment of cases before such time. In the absence of the 2003 Restructuring Order and the 2017 Continuation Order, tax relief would only be possible on the basis of equitable relief in exceptional circumstances. It appears obvious that no reliable restructuring concept can be based on potential equitable relief. Thus, it is advisable to look out for alternative structuring options in the interim: Subordination of debt: while this may eliminate an insolvency filing requirement for illiquidity or over indebtedness, the debt continues to exist. This may make it difficult for the debtor to obtain financing in the future. In certain circumstances, a carve-out of the assets together with a sustainable portion of the debt into a new vehicle while leaving behind and subordinating the remainder of the unsustainable portion of the debt, could be a feasible option. As the debt subsists, a silent liquidation of the debtor may not be possible considering the lingering tax burden on restructuring profits. Also, any such carve-out measures by which the debtor is stripped of assets may be challenged in case of a later insolvency of the debtor. A debt hive up without recourse may be a possible option, but a shareholder or its affiliates are not always willing to assume the debt. Also, as tax authorities have not issued any guidelines on the tax treatment of debt hive ups, a binding advance tax ruling from the tax authorities should be obtained before the debt hive up is executed. Still, a debt hive up could be an option if the replacement debtor is domiciled in a jurisdiction which does not impose detrimental tax consequences on the waiver of unsustainable debt. Converting the debt into a hybrid instrument which constitutes debt for German tax purposes and equity from a German GAAP perspective is no longer feasible. Pursuant to a tax decree from May 2016, the tax authorities argue that the creation of a hybrid instrument amounts to a taxable waiver of debt on the basis that tax accounting follows commercial accounting. It follows that irrespective of potential alternative structures which may suit a specific set of facts and circumstances, restructuring transactions in Germany continue to be challenging pending the entry into force of the new tax relief legislation. Back to Top 4. Labor and Employment 4.1       Labor and Employment – Defined Contribution Schemes Now Allowed In an effort to promote company pension schemes and to allow more flexible investments, the German Company Pension Act (Betriebsrentengesetz – BetrAVG) was amended considerably with effect as of January 1, 2018. The most salient novelty is the introduction of a purely defined contribution pension scheme, which had not been permitted in the past. Until now, the employer would always be ultimately liable for any kind of company pension scheme irrespective of the vehicle it was administered through. This is no longer the case with the newly introduced defined contribution scheme. The defined contribution scheme also entails considerable other easements for employers, e.g. pension adjustment obligations or the requirement of insolvency insurance no longer apply. As a consequence, a company offering a defined contribution pension scheme does not have to deal with the intricacies of providing a suitable investment to fulfil its pension promise, but will have met its duty in relation to the pension simply by paying the promised contribution (“pay and forget”). However, the introduction of such defined contribution schemes requires a legal basis either in a collective bargaining agreement (with a trade union) or in a works council agreement, if the union agreement so allows. If these requirements are met though, the new legal situation brings relief not only for employers offering company pension schemes but also for potential investors into German businesses for whom the German-specific defined benefit schemes have always been a great burden. Back to Top 4.2     Labor and Employment – Federal Labor Court Facilitates Compliance Investigations In a decision much acclaimed by the business community, the German Federal Labor Court (Bundesarbeitsgericht – BAG) held that intrusive investigative measures by companies against their employees do not necessarily require a suspicion of a criminal act by an employee; rather, less severe forms of misconduct can also trigger compliance investigations against employees (BAG, 2 AZR 597/16 – June 29, 2017). In the case at hand, an employee had taken sick leave, but during his sick leave proceeded to work for the company owned by his sons who happened to be competing against his current employer. After customers had dropped corresponding hints, the company assigned a detective to ascertain the employee’s violation of his contractual duties and subsequently fired the employee based on the detective’s findings. In the dismissal protection trial, the employee argued that German law only allowed such intrusive investigation measures if criminal acts were suspected. This restriction was, however, rejected by the BAG. This judgment ends a heated debate about the permissibility of internal investigation measures in the case of compliance violations. However, employers should always adhere to a last-resort principle when investigating possible violations. For instance, employees must not be seamlessly monitored at their workplace by way of a so-called “key logger” as the Federal Labor Court held in a different decision (BAG, 2 AZR 681/16 – July 27, 2017). Also, employers should keep in mind a recent ruling of the European Court of Human Rights of September 5, 2017 (ECHR, 61496/08). Accordingly, the workforce should be informed in advance that and how their email correspondence at the workplace can be monitored. Back to Top 5. Real Estate Real Estate – Invalidity of Written Form Remediation Clauses for Long-term Lease Agreements On September 27, 2017, the German Federal Supreme Court (Bundesgerichtshof – BGH) ruled that so-called “written form remediation clauses” (Schriftformheilungsklauseln) in lease agreements are invalid because they are incompatible with the mandatory provisions of section 550 of the German Civil Code (Bürgerliches Gesetzbuch – BGB; BGH, XII ZR 114/16 – September 27, 2017). The written form for lease agreements requires that all material agreements concerning the lease, in particular the lease term, identification of the leased premises and the rent amount, must be made in writing. If a lease agreement entered into for a period of more than one year does not comply with this written form requirement, mandatory German law allows either lease party to terminate the lease agreement with the statutory notice period irrespective of whether or not a fixed lease term was agreed upon. The statutory notice period for commercial lease agreements is six months (less three business days) to the end of any calendar quarter. To avoid the risk of termination for non-compliance with the written form requirement, German commercial lease agreements regularly contain a general written form remediation clause. Pursuant to such clause, the parties of the lease agreement undertake to remediate any defect in the written form upon request of one of the parties. While such general written form remediation clauses were upheld in several decisions by various Higher District Courts (Oberlandesgerichte) in the past, the BGH had already rejected the validity of such clauses vis-à-vis the purchasers of real property in 2014. With this new decision, the BGH has gone one step further and denied the validity of general written form remediation clauses altogether. Only in exceptional circumstances, the lease parties are not entitled to invoke the non-compliance with the written form requirement on account of a breach of the good faith principle. Such exceptional circumstances may exist, for example, if the other party faced insolvency if the lease were terminated early as a result of the non-compliance or if the lease parties had agreed in the lease agreement to remediate such specific written form defect. This new decision of the BGH forces the parties to long-term commercial lease agreements to put even greater emphasis on ensuring that their lease agreements comply with the written form requirement at all times because remediation clauses as potential second lines of defense no longer apply. Likewise, the due diligence process of German real estate transactions will have to focus even more on the compliance of lease agreements with the written form requirement. Back to Top 6.  Data Protection Data Protection – Employee Data Protection Under New EU Regulation After a two-year transition period, the EU General Data Protection Regulation (“GDPR“) will enter into force on May 25, 2018. The GDPR has several implications for data protection law covering German employees, which is already very strictly regulated. For example, under the GDPR any handling of personnel data by the employer requires a legal basis. In addition to statutory laws or collective agreements, another possible legal basis is the employee’s explicit written consent. The transfer of personnel data to a country outside of the European Union (“EU“) will have to comply with the requirements prescribed by the GDPR. If the target country has not been regarded as having an adequate data protection level by the EU Commission, additional safeguards will be required to protect the personnel data upon transfer outside of the EU. Otherwise, a data transfer is generally not permitted. The most threatening consequence of the GDPR is the introduction of a new sanctions regime. It now allows fines against companies of up to 4% of the entire group’s revenue worldwide. Consequently, these new features, especially the drastic new sanction regime, call for assessments of, and adequate changes to, existing compliance management systems with regard to data protection issues. Back to Top 7. Compliance 7.1       Compliance – Misalignment of International Sanction Regimes Requires Enhanced Attention to the EU Blocking Regulation and the German Anti-Boycott Provisions The Trump administration has been very active in broadening the scope and reach of the U.S. sanctions regime, most recently with the implementation of “Countering America’s Adversaries Through Sanctions Act (H.R. 3364) (‘CAATSA‘)” on August 2, 2017 and the guidance documents that followed. CAATSA includes significant new law codifying and expanding U.S. sanctions on Russia, North Korea, and Iran. The European Union (“EU“) has not followed suit. More so, the EU and European leaders openly stated their frustration about both a perceived lack of consultation during the process and the substance of the new U.S. sanctions. Specifically, the EU and European leaders are concerned about the fact that CAATSA authorizes secondary sanctions on any person supporting a range of activities. Among these are the development of Russian energy export pipeline projects, certain transactions with the Russian intelligence or defense sectors or investing in or otherwise facilitating privatizations of Russia’s state-owned assets that unjustly benefits Russian officials or their close associates or family members. The U.S. sanctions regime differentiates between primary sanctions that apply to U.S. persons (U.S. citizens, permanent U.S. residents and companies under U.S. jurisdiction) and U.S. origin goods, and secondary sanctions that expand the reach of U.S. sanctions by penalizing non-U.S. persons for their involvement in certain targeted activities. Secondary sanctions can take many forms but generally operate by restricting or threatening to restrict non-U.S. person access to the U.S. market, including its global financial institutions. European, especially export-heavy and internationally operating German companies are thus facing a dilemma. While they have to fear possible U.S. secondary sanctions for not complying with U.S. regulations, potential penalties also loom from European member state authorities when doing so. These problems are grounded in European and German legislation aimed at protecting from and counteracting financial and economic sanctions issued by countries outside of the EU and Germany, unless such sanctions are themselves authorized under relevant UN, European, and German sanctions legislation. On the European level, Council Regulation (EC) No 2271/96 of November, 22 1996 as amended (“EU Blocking Regulation“) is aimed at protecting European persons against the effects of the extra-territorial application of laws, such as certain U.S. sanctions directed at Cuba, Iran and Libya. Furthermore, it also aims to counteract the effects of the extra-territorial application of such sanctions by prohibiting European persons from complying with any requirement or prohibition, including requests of foreign courts, based on or resulting, directly or indirectly, from such U.S. sanctions. For companies subject to German jurisdiction, section 7 of the German Foreign Trade and Payments Ordinance (Außenwirtschaftsverordnung – AWV), states that “[t]he issuing of a declaration in foreign trade and payments transactions whereby a resident participates in a boycott against another country (boycott declaration) shall be prohibited” to the extent such a declaration would be contradictory to UN, EU and German policy. With the sanctions regime on the one hand and the blocking legislation at EU and German level on the other hand, committing to full compliance with U.S. sanctions whilst falling within German jurisdiction, could be deemed a violation of the AWV.  Violating the AWV can lead to fines by the German authorities and, under German civil law, might render a relevant contractual provision invalid. For companies conducting business transactions on a global scale, the developing non-alignment of U.S. and European / German sanctions requires special attention. Specifically, covenants with respect to compliance with U.S. or other non-EU sanctions should be reviewed and carefully drafted in light of the diverging developments of U.S. and other non-EU sanctions on the one hand and European / German sanctions on the other hand. Back to Top 7.2       Compliance – Restated (Anti-) Money Laundering Act – Significant New Requirements for the Non-Financial Sector and Good Traders On June 26, 2017, the restated German Money Laundering Act (Geldwäschegesetz – GWG), which transposes the 4th European Anti-Money Laundering Directive (Directive (EU 2015/849 of the European Parliament and of the Council) into German law, became effective. While the scope of businesses that are required to conduct anti-money laundering procedures remains generally unchanged, the GWG introduced a number of new requirements, in particular for non-financial businesses, and significantly increases the sanctions for non-compliance with these obligations. The GWG now extends anti money laundering (“AML“) risk management concepts previously known from the financial sector also to non-financial businesses including good traders. As a matter of principle, all obliged businesses are now required to undertake a written risk analysis for their business and have in place internal risk management procedures proportionate to the type and scope of the business and the risks involved in order to effectively mitigate and manage the risks of money laundering and terrorist financing. In case the obliged business is the parent company of a group, a group-wide risk analysis and group-wide risk management procedures are required covering subsidiaries worldwide who also engage in relevant businesses. The risk analysis must be reviewed regularly, updated if required and submitted to the supervisory authority upon request. Internal risk management procedures include, in particular, client due diligence (“know-your customer”), which requires the identification and verification of customers, persons acting on behalf of customers as well as of beneficial owners of the customer (see also section 1.1 above on the Transparency Register). In addition, staff must be monitored for their reliability and trained regularly on methods and types of money laundering and terrorist financing and the applicable legal obligations under the GWG as well as data protection law, and whistle-blowing systems must be implemented. Furthermore, businesses of the financial and insurance sector as well as providers of gambling services must appoint a money laundering officer (“MLO“) at senior management level as well as a deputy, who are responsible for ensuring compliance with AML rules. Other businesses may also be ordered by their supervisory authority to appoint a MLO and a deputy. Good traders including conventional industrial companies are subject to the AML requirements under the GWG, irrespective of the type of goods they are trading in. However, some of the requirements either do not apply or are significantly eased. Good traders must only conduct a risk analysis and have in place internal AML risk management procedures if they accept or make (!) cash payments of EUR 10,000 or more. Furthermore, client due diligence is only required with respect to transactions in which they make or accept cash payments of EUR 10,000 or more, or in case there is a suspicion of money laundering or terrorist financing. Suspicious transactions must be reported to the Financial Intelligence Unit (“FIU“) without undue delay. As a result, also low cash or cash free good traders are well advised to train their staff to enable them to detect suspicious transactions and to have in place appropriate documentation and reporting lines to make sure that suspicious transactions are filed with the FIU. Non-compliance with the GWG obligations can be punished with administrative fines of up to EUR 100,000. Serious, repeated or systematic breaches may even trigger sanctions up to the higher fine threshold of EUR 1 million or twice the economic benefit of the breach. For the financial sector, even higher fines of up to the higher of EUR 5 million or 10% of the total annual turnover are possible. Furthermore, offenders will be published with their names by relevant supervisory authorities (“naming and shaming”). Relevant non-financial businesses are thus well advised to review their existing AML compliance system in order to ensure that the new requirements are covered. For good traders prohibiting cash transactions of EUR 10,000 or more and implementing appropriate safeguards to ensure that the threshold is not circumvented by splitting a transaction into various smaller sums, is a first and vital step. Furthermore, holding companies businesses who mainly acquire and hold participations (e.g. certain private equity companies), must keep in mind that enterprises qualifying as “finance enterprise” within the meaning of section 1 (3) of the German Banking Act (Kreditwesengesetz – KWG) are subject to the GWG with no exemptions. Back to Top  7.3       Compliance – Protection of the Attorney Client Privilege in Germany Remains Unusual The constitutional complaint (Verfassungsbeschwerde) brought by Volkswagen AG’s external legal counsel requesting the return of work product prepared during the internal investigation for Volkswagen AG remains pending before the German Federal Constitutional Court (Bundesverfassungsgericht – BVerfG). The Munich public prosecutors had seized these documents in a dawn raid of the law firm’s offices. While the BVerfG has granted injunctive relief (BVerfG, 2 BvR 1287/17, 2 BvR 1583/17 – July 25, 2017) and ordered the authorities, pending a decision on the merits of the case, to refrain from reviewing the seized material, this case is a timely reminder that the concept of the attorney client privilege in Germany is very different to that in common law jurisdictions. In a nutshell: In-house lawyers do not enjoy legal privilege. Material that would otherwise be privileged can be seized on the client’s premises – with the exception of correspondence with and work product from / for criminal defense counsel. The German courts are divided on the question of whether corporate clients can already appoint criminal defense counsel as soon as they are concerned that they may be the target of a future criminal investigation, or only when they have been formally made the subject of such an investigation. Searches and seizures at a law firm, however, are a different matter. A couple of years ago, the German legislator changed the German Code of Criminal Procedure (Strafprozessordnung – StPO) to give attorneys in general, not only criminal defense counsel, more protection against investigative measures (section 160a StPO). Despite this legislation, the first and second instance judges involved in the matter decided in favor of the prosecutors. As noted above, the German Federal Constitutional Court has put an end to this, at least for now. According to the court, the complaints of the external legal counsel and its clients were not “obviously without any merits” and, therefore, needed to be considered in the proceedings on the merits of the case. In order not to moot these proceedings, the court ordered the prosecutors to desist from a review of the seized material, and put it under seal until a full decision on the merits is available. In the interim period, the interest of the external legal counsel and its clients to protect the privilege outweighed the public interest in a speedy criminal investigation. At this stage, it is unclear when and how the court will decide on the merits. Back to Top 7.4       Compliance – The European Public Prosecutor’s Office Will Be Established – Eventually After approximately four years of discussions, 20 out of the 28 EU member states agreed in June 2017 on the creation of a European Public Prosecutor’s Office (“EPPO“). In October, the relevant member states adopted the corresponding regulation (Regulation (EU) 2017/1939 – “Regulation“). The EPPO will be in charge of investigating, prosecuting and bringing to justice the perpetrators of offences against the EU’s financial interests. The EPPO is intended to be a decentralized authority, which operates via and on the basis of European Delegated Prosecutors located in each member state. The central office in Luxembourg will have a European Chief Prosecutor supported by 20 European Prosecutors, as well as technical and investigatory staff. While EU officials praise this Regulation as an “important step in European justice cooperation“, it remains to be seen whether this really is a measure which ensures that “criminals [who] act across borders […] are brought to justice and […] taxpayers’ money is recovered” (U. Reinsalu, Estonian Minister of Justice). It will take at least until 2020 until the EPPO is established, and criminals will certainly not restrict their activities to the territories of those 20 countries which will cooperate under the new authority (being: Austria, Belgium, Bulgaria, Croatia, Cyprus, Czech Republic, Estonia, Germany, Greece, Finland, France, Italy, Latvia, Lithuania, Luxembourg, Portugal, Romania, Slovenia, Slovakia and Spain). In addition, as the national sovereignty of the EU member states in judicial matters remains completely intact, the EPPO will not truly investigate “on the ground”, but mainly assume a coordinating role. Last but not least, its jurisdiction will be limited to “offences against the EU’s financial interests”, in particular criminal VAT evasion, subsidy fraud and corruption involving EU officials. A strong enforcement, at least prima facie, looks different. To end on a positive note, however: the new body is certainly an improvement on the status quo in which the local prosecutors from 28 member states often lack coordination and team spirit. Back to Top 7.5       Compliance – Court Allows for Reduced Fines in Compliance Defense Case The German Federal Supreme Court (Bundesgerichtshof – BGH) handed down a decision recognizing for the first time that a company’s implementation of a compliance management system (“CMS“) constitutes a mitigating factor for the assessment of fines imposed on such company where violations committed by its employees are imputed to the company (BGH 1 StR 265/16 – May 9, 2017). According to the BGH, not only the implementation of a compliance management system at the time of the detection of the offense should be considered, but the court may also take into account subsequent efforts of a company to enhance its respective internal processes that were found deficient. The BGH held that such remediation measures can be considered as a mitigating factor when assessing the amount of fines if they are deemed suitable to “substantially prevent an equivalent violation in the future.” The BGH’s ruling has finally clarified the highest German court’s views on a long-lasting discussion about whether establishing and maintaining a CMS may limit a company’s liability for legal infringements. The recognition of a company’s efforts to establish, maintain and improve an effective CMS should encourage companies to continue working on their compliance culture, processes and systems. Similarly, management’s efforts to establish, maintain and enhance a CMS, and conduct timely remediation measures, upon becoming aware of deficiencies in the CMS, may become relevant factors when assessing potential civil liability exposure of corporate executives pursuant to section. 43 German Limited Liability Companies Act (Gesetz betreffend Gesellschaften mit beschränkter Haftung – GmbHG) and section 93 (German Stock Companies Act (Aktiengesetz – AktG). Consequently, the implications of this landmark decision are important both for corporations and their senior executives. Back to Top 8.  Antitrust and Merger Control In 2017, the German Federal Cartel Office (Bundeskartellamt – BKartA) examined about 1,300 merger filings, imposed fines in the amount of approximately EUR 60 million on companies for cartel agreements and conducted several infringement proceedings. On June 9, 2017, the ninth amendment to the German Act against Restraints of Competition (Gesetz gegen Wettbewerbsbeschränkungen – GWB) came into force. The most important changes concern the implementation of the European Damages Directive (Directive 2014/104/EU of the European Parliament and of the Council of November, 26 2014), but a new merger control threshold was also introduced into law. Implementation of the European Damages Directive The amendment introduced various procedural facilitations for claimants in civil cartel damage proceedings. There is now a refutable presumption in favor of cartel victims that a cartel caused damage. However, the claimant still has the burden of proof regarding the often difficult to argue fact, if it was actually affected by the cartel and the amount of damages attributable to the infringement. The implemented passing-on defense allows indirect customer claimants to prove that they suffered damages from the cartel – even if not direct customers of the cartel members – because the intermediary was presumably able to pass on the cartel overcharge to his own customers (the claimants). The underlying refutable presumption that overcharges were passed on is not available in the relationship between the cartel member and its direct customer because the passing-on defense must not benefit the cartel members. In deviation from general principles of German civil procedural law, according to which each party has to produce the relevant evidence for the facts it relies on, the GWB amendment has significantly broadened the scope for requesting disclosure of documents. The right to request disclosure from the opposing party now to a certain degree resembles discovery proceedings in Anglo-American jurisdictions and has therefore also been referred to as “discovery light”. However, the documents still need to be identified as precisely as possible and the request must be reasonable, i.e., not place an undue burden on the opposing party. Documents can also be requested from third parties. Leniency applications and settlement documents are not captured by the disclosure provisions. Furthermore, certain exceptions to the principle of joint and several liability of cartelists for damage claims in relation to (i) internal regress against small and medium-sized enterprises, (ii) leniency applicants, and (iii) settlements between cartelists and claimants were implemented. In the latter case, non-settling cartelists may not recover contribution for the remaining claim from settling cartelists. Finally, the regular limitation period for antitrust damages claims has been extended from three to five years. Cartel Enforcement and Corporate Liability Parent companies can now also be held liable for their subsidiary’s anti-competitive conduct under the GWB even if they were not party to the infringement themselves. The crucial factor – comparable to existing European practice – is the exercise of decisive control. Furthermore, legal universal successors and economic successors of the infringer can also be held liable for cartel fines. This prevents companies from escaping cartel fines by restructuring their business. Publicity The Bundeskartellamt has further been assigned the duty to inform the public about decisions on cartel fines by publishing details about such decisions on its webpage. Taking into account recent efforts to establish a competition register for public procurement procedures, companies will face increased public attention for competition law infringements, which may result in infringers being barred from public or private contracting. Whistleblower Hotline Following the example of the Bundeskartellamt and other antitrust authorities, the European Commission (“Commission“) has implemented a whistleblowing mailbox. The IT-based system operated by an external service provider allows anonymous hints to or bilateral exchanges with the Commission – in particular to strengthen its cartel enforcement activities. The hope is that the whistleblower hotline will add to the Commission’s enforcement strengths and will balance out potentially decreasing leniency applications due to companies applying for leniency increasingly facing the risk of private cartel damage litigation once the cartel has been disclosed. Merger Control Thresholds To provide for control over transactions that do not meet the current thresholds but may nevertheless have significant impact on the domestic market (in particular in the digital economy), a “size of transaction test” was implemented; mergers with a purchase price or other consideration in excess of EUR 400 million now require approval by the Bundeskartellamt if at least two parties to the transaction achieve at least EUR 25 million and EUR 5 million in domestic turnover, respectively. Likewise, in Austria a similar threshold was established (EUR 200 million consideration plus a domestic turnover of at least EUR 15 million). The concept of ministerial approval (Ministererlaubnis), i.e., an extra-judicial instrument for the Minister of Economic Affairs to exceptionally approve mergers prohibited by the Bundeskartellamt, has been reformed by accelerating and substantiating the process. In May 2017, the Bundeskartellamt published guidance on remedies in merger control making the assessment of commitments more transparent. Remedies such as the acceptance of conditions (Bedingungen) and obligations (Auflagen) can facilitate clearance of a merger even if the merger actually fulfils the requirements for a prohibition. The English version of the guidance is available at: http://www.bundeskartellamt.de/SharedDocs/Publikation/EN/Leitlinien/Guidance%20on%20Remedies%20in%20Merger%20Control.html; jsessionid=5EA81D6D85D9FD8891765A5EA9C26E68.1_cid378?nn=3600108. Case Law Finally on January 26, 2017, there has been a noteworthy decision by the Higher District Court of Düsseldorf (OLG Düsseldorf, Az. V-4 Kart 4/15 OWI – January 26, 2017; not yet final): The court confirmed a decision of the Bundeskartellamt that had imposed fines on several sweets manufacturers for exchanging competitively sensitive information and even increased the fines. This case demonstrates the different approach taken by courts in calculating cartel fines based on the group turnover instead of revenues achieved in the German market. Back to Top     The following Gibson Dunn lawyers assisted in preparing this client update:  Birgit Friedl, Marcus Geiss, Jutta Otto, Silke Beiter, Peter Decker, Ferdinand Fromholzer, Daniel Gebauer, Kai Gesing, Franziska Gruber, Johanna Hauser, Maximilian Hoffmann, Markus Nauheim, Richard Roeder, Katharina Saulich, Martin Schmid, Sebastian Schoon, Benno Schwarz, Michael Walther, Finn Zeidler, Mark Zimmer and Caroline Ziser Smith. Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding the issues discussed in this update. The two German offices of Gibson Dunn in Munich and Frankfurt bring together lawyers with extensive knowledge of corporate / M&A, financing, restructuring and bankruptcy, tax, labor, real estate, antitrust, intellectual property law and extensive compliance / white collar crime experience. The German offices are comprised of seasoned lawyers with a breadth of experience who have assisted clients in various industries and in jurisdictions around the world. Our German lawyers work closely with the firm’s practice groups in other jurisdictions to provide cutting-edge legal advice and guidance in the most complex transactions and legal matters. For further information, please contact the Gibson Dunn lawyer with whom you work or any of the following members of the German offices: General Corporate, Corporate Transactions and Capital Markets Lutz Englisch (+49 89 189 33 150), lenglisch@gibsondunn.com) Markus Nauheim (+49 89 189 33 122, mnauheim@gibsondunn.com) Ferdinand Fromholzer (+49 89 189 33 170, ffromholzer@gibsondunn.com) Dirk Oberbracht (+49 69 247 411 510, doberbracht@gibsondunn.com) Wilhelm Reinhardt (+49 69 247 411 520, wreinhardt@gibsondunn.com) Birgit Friedl (+49 89 189 33 180, bfriedl@gibsondunn.com) Silke Beiter (+49 89 189 33 170, sbeiter@gibsondunn.com) Marcus Geiss (+49 89 189 33 122, mgeiss@gibsondunn.com) Annekatrin Pelster (+49 69 247 411 521, apelster@gibsondunn.com) Finance, Restructuring and Insolvency Sebastian Schoon (+49 89 189 33 160, sschoon@gibsondunn.com) Birgit Friedl (+49 89 189 33 180, bfriedl@gibsondunn.com) Marcus Geiss (+49 89 189 33 122, mgeiss@gibsondunn.com) Tax Hans Martin Schmid (+49 89 189 33 110, mschmid@gibsondunn.com) Labor Law Mark Zimmer (+49 89 189 33 130, mzimmer@gibsondunn.com) Real Estate Peter Decker (+49 89 189 33 115, pdecker@gibsondunn.com) Daniel Gebauer (+ 49 89 189 33 115, dgebauer@gibsondunn.com) Technology Transactions / Intellectual Property / Data Privacy Michael Walther (+49 89 189 33 180, mwalther@gibsondunn.com) Kai Gesing (+49 89 189 33 180, kgesing@gibsondunn.com) Corporate Compliance / White Collar Matters Benno Schwarz (+49 89 189 33 110, bschwarz@gibsondunn.com) Michael Walther (+49 89 189 33 180, mwalther@gibsondunn.com) Mark Zimmer (+49 89 189 33 130, mzimmer@gibsondunn.com) Finn Zeidler (+49 69 247 411 530, fzeidler@gibsondunn.com) Antitrust and Merger Control Michael Walther (+49 89 189 33 180, mwalther@gibsondunn.com) Kai Gesing (+49 89 189 33 180, kgesing@gibsondunn.com) © 2018 Gibson, Dunn & Crutcher LLP, 333 South Grand Avenue, Los Angeles, CA 90071 Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

November 24, 2017 |
International Investors to Be Liable to UK Tax on Capital Gains Derived from UK Real Estate from 2019

Click for PDF Background 1.1          The UK has the largest commercial property market in Europe, attracting over $31bn of investment in the first half of 2017 (even after the Brexit vote). International investors dominate in London, lured by big buildings with long leases to established businesses and a stable legal environment – international investors account for about 75% of investment in property in central-London. 1.2          The UK traditionally had not taxed international investors on capital gains derived from investment in UK land and buildings. As such, the UK has long been a favoured destination for international real estate investors who have, year after year, consistently invested billions of dollars, euros, and pounds into both commercial and residential schemes. As compared with its peers, the UK has always been viewed as one of the most favourable real estate markets on the globe. The landscape may be about to change. 1.3          It has always taxed rental income (although with a generous deduction allowed for interest costs incurred on acquisition finance). Since 2013, the UK has imposed taxation on international investors on gains derived from some residential UK property, and these provisions were broadened in 2015. 1.4          The UK Government announced in the Autumn 2017 Budget (22 November 2017) that tax will be charged on gains made by international investors on disposals of all types of UK land and buildings – residential and commercial, and whether held owned directly or indirectly. The proposed changes extend the existing rules that apply to residential property and are due to come into effect from April 2019. 1.5          The UK Government has published a consultation document (“Consultation Document”)[1]  on the implementation of the new taxation regime. The Consultation Document proposes that a single regime will be created for the disposal of interests in both residential and non-residential property. 1.6          The proposed rules are intended to apply not only to direct disposals of UK immovable property, but also to indirect disposals – in other words the sale of interests in entities whose value is derived from UK land and buildings. 1.7          Anti-forestalling measures will be introduced with effect from 22 November 2017 (being the day on which the announcement was made), to prevent circumvention of the tax through “treaty shopping”. Autumn Budget 2017 Consultation Document 2.1          The Consultation Document makes it clear that the UK Government’s policy is to amend the law with effect from April 2019 to bring non-UK residents within the charge to UK tax on disposals of all kinds of UK immoveable property, more closely aligning the tax treatment of non-UK residents with that of UK residents, and reducing the incentive for multinational groups to hold UK land and buildings through offshore structures. 2.2         The consultation being conducted relates to the implementation of this policy, not to its principle. In the current political climate in the UK, our view is that it is highly likely that the proposals in the Consultation Document will be implemented. Direct disposals 3.1          The UK Government intends that all gains accruing on disposals of interests in UK immovable property will become chargeable to UK tax with effect from April 2019. 3.2         Non-residents will be taxed on any gains made on the direct disposal of UK land and buildings. In addition, disposals by non-resident widely-held companies will be brought into charge to tax. 3.3         The rate of tax on any direct disposals will be the UK capital gains tax (subject to the move to corporation tax for corporate owners – see below). 3.4         Non-residential property already owned as at April 2019 will be re-based to its April 2019 value – with the intention that non-residential property will only be taxed to the extent of its appreciation in value after April 2019. 3.5         Gains arising on the disposal of residential property are already within the scope of UK tax, and the re-basing point for residential property will remain at April 2015. In cases of mixed-use property (where the property includes both residential and non-residential elements), or in the case of change of use (for example, the conversion of residential property to non-residential use, or vice versa in the period between April 2015 and April 2019), there will need to be an allocation of the gain between the different elements, using the different rebasing points. 3.6         The NRCGT regime currently excludes widely-held companies from the scope of tax. That exemption will be removed with effect from April 2019. 3.7         Gains will be computed in the same way as for UK resident investors. Any losses arising on the disposal of UK property will be available for offset against UK taxable gains. For companies within the scope of corporation tax, the losses will be treated in the same way as other capital gains and losses for corporation tax purposes. For other investors, capital losses will be available for offset against capital gains arising on the disposal of other UK property. 3.8         Owners who are exempt from UK tax, otherwise than because of their non-resident status (such as certain pension schemes or sovereign investors), will be exempt from the tax. 3.9         If the property owner has made an overall loss on a direct disposal of the property, but re-basing results in a taxable gain, there will be an option for the loss to be computed using the original acquisition cost. Indirect disposals 4.1          Disposals of significant interests in entities that own (directly or indirectly) interests in UK real estate will also be brought within the scope of UK tax. 4.2         The following tests must be met at the date of disposal in order for a tax charge to be imposed: 4.2.1      The entity being disposed must be “property rich”; and 4.2.2     The non-resident must hold a 25% or greater interest in the entity, or have held 25% or more at some point in the five years ending on that date 4.3         Property Rich:  An entity is “property rich”, if 75% or more of its gross asset value as at the time of the disposal is derived from UK immovable property. This includes any shareholding in a company deriving its value directly and indirectly from the UK property, any partnership interests, any interest in settled property as well as any option, consent or embargo affecting the disposition of the UK property. The test looks through layers of ownership to arrive at a just and reasonable attribution of value. The value of both residential and non-residential UK properties will count towards the 75%. However, the value of non-UK property will not count towards the 75%. 4.4         The property richness test is applied to the gross value of the entity’s assets, so liabilities such as acquisition finance are excluded in making the assessment. The test uses the market value of the assets of the entity at the time of the disposal. 4.5         If an entity is not property rich at the time the investor acquires his investment, but becomes property rich subsequently, the whole of the gain is within the scope of UK tax – not just the amount attributable to the period after the company becomes property rich (subject to April 2019 rebasing). Rebasing to April 2019 is the only calculation permitted for investments held prior to that date (the ability to use original acquisition cost is not permitted for indirect disposals). 4.6         25% Ownership:  The 25% ownership test is intended to exclude minority investors who may not necessarily be aware of the underlying asset mix of the entity, and who are unlikely to have control or influence over the entity’s activities. 4.7         In determining whether an owner has a 25% interest, the owner will need to look back over five years to see if the test was met at any time in the five-year period. In addition, holdings of related parties will also be taken into account in the determination. For these purposes, related parties will include persons who are “connected” (using the existing rules in the UK Corporation Tax Act) but also persons “acting together”, to include situations where persons come together with a common object in relation to a UK property owning entity. The “acting together” rules will be modelled on those in the UK’s corporate interest restriction provisions. 4.8         Although the tax charge will be limited to gains accruing after April 2019 (because of the re-basing), the “look back” would take account of holdings of the owner prior to April 2019 (if that falls within the 5 year look-back period). So an investor who currently owns 50% of a UK property investment company, but sells down to 24% before April 2019, would not avoid the new tax charge if she or he sold the remaining holding before 2024 (the tax charge would be limited to the appreciation of the value of the 24% stake, and would be re-based to April 2019 values). 4.9         Groups:  The property richness test will be applied to the totality of entities being sold in a transaction. So if an investor were to sell shares in a holding company which was not itself property-rich, but which owned entities that were, the 75% test would be satisfied if, taken together, the entities being sold met the 75% test. 4.10       Calculation of gain:  Gains will be calculated on the basis of the interest being sold, using the normal rules that apply to the disposal of shares (or other investments). Anti-avoidance provisions will apply in the same way as they would to UK resident taxpayers. Investors who are exempt from UK tax, otherwise than because of their non-resident status (such as certain pension schemes), will be exempt from the tax. 4.11        Substantial shareholder exemption:  The Finance (No 2) Act 2017 introduced changes to the substantial shareholder exemption (“SSE”) to extend the exemption to qualifying institutional investors. SSE will apply to disposals of property rich companies (or groups) by such investors. Residential property 5.1          The current NRCGT rules apply only to direct disposals, and do not apply to disposals by widely-held companies. 5.2         NRCGT will be amended so that it extends to widely-held companies, and also to bring indirect disposals within the scope of the tax. The exemption within NRCGT for life-assurance companies owning residential properties will also be removed. 5.3         Widely-held companies will use April 2019 as the NRCGT rebasing point for all property disposals (both residential and non-residential). Closely-held companies will continue to use April 2015 as the rebasing point for direct disposals of residential property (and will use April 2019 for disposals of non-residential property). 5.4         April 2019 will be the NRCGT rebasing point for all disposals of indirect interests. 5.5         The NRCGT rules will extend to widely held companies whereby any disposals of UK residential property will be charged to corporation tax. Non-resident close companies disposing of residential property will also be charged corporation tax instead of capital gains tax. 5.6         The UK Government is considering harmonising the existing regime for ATED-related gains with the wider proposals for taxing non-resident gains on UK immovable property, and one of the areas of consultation within the Consultation Document relates to the simplification and harmonisation of the ATED rules. Double Tax Treaties 6.1          It is generally accepted that the primary taxing rights over immoveable property (such as land and buildings) belongs to the state in which the immovable property is located. 6.2         As historically the UK has not exercised this right, it has not been concerned to ensure that this right is fully reflected in its double tax treaties. A number of treaties will require amendment to give the UK full taxing rights in relation to indirect disposals. In the meantime, the impact of a particular treaty may be to exempt from UK tax a disposal of an indirect interest in UK land and buildings – this is subject to the anti-forestalling provisions described below. 6.3         All of the UK’s double tax treaties include a provision allowing the UK to impose tax on a direct disposal of UK immoveable property. 6.4         Most (but not all) of the UK’s tax treaties include a “securitised land” provision, which allows the UK to impose tax on gains on the disposal of interests in entities that are UK-property rich. 6.5         But some older treaties do not include a securitised land provision, and these allocate taxing rights on the disposal of interests in a UK-property rich entity to the country of residence of the investor, and not the UK. Even where a treaty includes a securitised land provision, some apply only to shares in companies, and not to interests in other entities (such as partnerships or unit trusts), and in some of the treaties, the securitised land provisions apply only to the disposal by the investor of the interest it holds in the entity, and would not apply to disposals by underlying entities. In these cases, the UK’s taxing rights will be limited. 6.6         In cases where no tax treaty exists, the UK will be able to apply the indirect disposal charge without constraint. 6.7         Where a doubt tax treaty does exist, but does not allow the UK to tax indirect disposals without constraint, the UK government has announced its intention to negotiate with the other state to amend the treaty. Subject to the anti-forestalling provisions, if a non-resident investor disposes of his interest in a UK-property rich entity prior to the amendment taking effect, then the investor may be able to benefit from any exemption from UK tax in the treaty. 6.8         However, an anti-forestalling rule will apply to prevent investors from being able to reorganise their affairs in order to take advantage of a treaty exemption to which they are not already entitled. The anti-forestalling rule will apply to any arrangements entered into or after 22 November 2017 with the intention of obtaining a tax advantage relating to these new tax provisions through the operation of the provisions of a double tax treaty exemption. In these circumstances, HMRC will have the power to counteract the tax advantage by means of a tax assessment or the disallowance of a claim. Collective Investment Vehicles 7.1          UK REITs:  The profits and gains of the property rental business of a UK REIT are exempt from tax, and there is no intention to change this rule. A UK REIT is required to distribute at least 90% of its rental income by way of dividend, which is then taxed in the hands of its shareholders. There is no requirement for a UK REIT to distribute capital gains, but if those gains are distributed by way of dividend, those dividends will also be taxable in the hands of shareholders. 7.2         Currently UK residents shareholders are taxed on gains realised on the disposal of shares in a UK REIT, whereas non-resident shareholders are not. Under the new rules, if a UK REIT satisfies the property richness test, then a non-resident disposing of shares in the UK REIT will be within the scope of UK tax (if the non-resident has a 25% or greater interest in the REIT at the time of disposal or in the prior 5 years). 7.3         The intention is that a similar analysis would apply to other UK collective investment vehicles (such as property authorised investment funds and exempt unauthorised unit trusts), and the vehicle itself would not be liable to tax on the direct disposal of UK property. However, a non-resident investor would be liable to UK tax on a disposal of its investment in the vehicle (assuming the vehicle was “property rich” and the investor’s interest exceeded 25% (at the time of disposal or in the prior five years). 7.4         Overseas collective investment vehicles: Some funds are outside the scope of UK tax on capital gains only because of their non-resident status. This will change with the new rules. Direct disposals by such collective vehicles will come within the scope of UK tax with effect from April 2019. And from that same date, disposals by investors of their interests in such vehicles will also become taxable (assuming the vehicle was “property rich” and the investor’s interest exceeded 25% (at the time of disposal or in the prior five years). Corporation tax 8.1          In March 2017, the UK Government published its consultation on “Non-resident companies chargeable to Income Tax and Non-resident CGT”, which sought views on bringing closely held companies that own UK property within the scope of UK corporation tax. 8.2         A response to that consultation is expected to be published shortly, but the indication is that non-UK resident companies that own UK property will be brought within the scope of UK corporation tax as regards their UK property business. 8.3         The move to the corporation tax regime will have the effect of reducing the headline tax rate for such companies. The Government has announced that the main corporation tax rate will be 19% for the financial years 2018 and 2019, and will reduce to 17% for the financial year 2020. 8.4         In addition, the regime for tax reliefs for financing costs is somewhat more flexible under corporation tax rules than under income tax rules, and technical issues that can arise when a property is refinanced should no longer apply. 8.5         However, companies within the scope of corporation tax are subject to interest restrictions (broadly 30% of consolidated “tax EBITDA” with a de minimis of £2 million), and to the ability to carry-forward losses. There are limited exceptions for public infrastructure projects. These rules are complicated and outside the scope of this alert as are the application of the hybrid entity rules and the carry-forward loss limitations, which will also become applicable. Administration and compliance 9.1          Non-resident direct owners of UK property are already within the scope of UK tax (at least as regards rental income) and will be filing UK tax returns in respect of rental income under the Non-Resident Landlord Scheme. However, investors in property-rich entities will not be used to filing UK tax returns. 9.2         HMRC anticipate that most persons within the scope of the new charge will be aware of their obligations to file UK tax returns and pay UK tax, and will be compliant. But in order to ensure that HMRC are aware of transactions, reporting obligations will be imposed on professional advisors, as described below. 9.3         Under the current NRCGT 9.3 regime, a transaction must be reported by the seller to HMRC electronically within 30 days of completion. If the seller is already within the self-assessment regime, they may defer payment of the tax until the tax is due under the normal reporting process. Otherwise, they must pay within 30 days. The same process will apply to the new charge for investors who are not within the scope of corporation tax. This will apply to direct and indirect disposals, and for residential and non-residential properties. 9.4         For companies within the charge to corporation tax, they will be required to register for self-assessment with HMRC, and return (and pay) any tax within the normal corporation tax self-assessment process. 9.5         So that HMRC will become aware of indirect disposals, reporting obligations will be imposed on advisors who meet the following conditions: 9.5.1      The advisor is based in the UK; 9.5.2     The advisor is paid a fee for advice or services relating to a transaction within the new rules; 9.5.3      The advisor has reason to believe that a contract has been concluded for a disposal falling within the new regime; 9.5.4     The advisor cannot reasonably satisfy themselves that the transaction has been reported to HMRC. 9.6         The time limit for the advisor is 60 days – which should allow time for the non-resident to report the transaction himself, and show an official receipt for its report to its advisor. 9.7         HMRC will have powers to recover unpaid tax from a UK representative of a non-resident investor and from related companies. 9.8 Penalties and interest charges will be imposed for compliance failures. Conclusions 10.1        In some respects, the move by the UK Government to impose tax on foreign investors in UK real estate should come as no surprise. In a time of austerity, raising tax receipts is an important part of the public finances, and seeking tax from overseas investors (who have no vote) is an obvious target. 10.2       Imposing capital gains tax on international investors in real estate brings the UK in line with most other jurisdictions. 10.3       At the moment, all we have is a consultation document. The Government has stated that it will publish its response to the consultation in Summer 2018, together with draft legislation. The actual legislation will be introduced with the Finance Bill in April 2019, to take effect from April 2019. Until we have sight of the draft legislation, it is difficult to provide anything other than a high level overview of the proposals. 10.4       However, there are some immediate thoughts that come to mind. 10.5       First, consideration should be given to the timing of capital expenditure. If an amount to be spent on capex will not be immediately reflected in the value of the building, consideration should be given to deferring the expenditure until after April 2019. This is so the full amount of the expenditure is treated as “enhancement” expenditure for base cost purposes, rather than getting lost in the rebasing valuation as at April 2019. 10.6       Second, if property is currently owned through a company incorporated and resident in a country with a favourable tax treaty with the UK, disposals of interests in such company may be exempted from the new indirect disposal charge under the terms of the treaty (which under UK general tax rules will trump domestic law), at least until such time as the UK and the other jurisdiction amend the treaty (and, unless the new multilateral instrument process can be utilised, the process of amending tax treaties is rarely rapid). To the extent that such structures can be kept in place without changes, they should. 10.7       However, the anti-forestalling provisions will counteract any attempt to redomicile a structure that does not already benefit from treaty reliefs into a favourable treaty jurisdiction. Quite how the anti-forestalling provisions will apply is not stated in HMRC’s technical note, and may be challenging to implement without the consent of the other jurisdiction involved. 10.8       Third, international investors, who benefit from UK tax exemptions (otherwise than because of their non-resident status), may want to restructure their ownership arrangements in order to benefit from their tax-exempt status, particularly if they own UK property through special purpose vehicles resident outside the UK.. This could be of particular relevance to overseas pension funds and sovereign investors, who would not be liable to UK tax if they hold property directly (or through fiscally transparent entities). Any restructuring may need to be put into place before April 2019 to ensure that the restructuring does not itself trigger a tax charge under the new regime. 10.9       Fourth, the structure of the proposed arrangements can give rise to the possibility of tax being charged at multiple levels where property is held by an international property investment funds through SPVs. Depending upon the proportion of UK and non-UK properties held by the fund, charges could arise on the disposal of individual SPVs (owning UK properties) and on the disposal by investors in their holding in the fund. Staging and timing of disposals may be important to mitigate the impact of potential double tax charges, so that at the point at which investors realise their holding in the fund, it is no longer “property rich”. 10.10     Fifth, The use of tax efficient onshore-UK structures (such as UK REITs, PAIFs and ACSs), is likely to become more prevalent, if only to restrict any tax charge to just one layer, and not at multiple levels. However, the Consultation Document does state that the Government will be considering whether changes to these regimes will be required to prevent tax avoidance. 10.11      Sixth, the interaction between these new provisions and the Substantial Shareholder Exemption is not entirely clear from the Consultation Document. Whilst the application of SSE to Qualifying Institutional Investors is clearly preserved, it is unclear whether SSE would be available for disposals that would otherwise qualify for the SSE. This is of particular importance to active trading businesses (such as hotels and care homes) that have a significant property component to their overall valuation. In the case of OpCo-PropCo structures, depending upon how the provisions are legislated, there might be benefits in migrating PropCos into the UK so that they clearly qualify for SSE on a disposal of the entire business. 10.12     Finally, challenges will also bring opportunities. Although some investors may find that their after-tax return from UK property investment will be diminished as a result of these changes, investors who are already within the scope of UK tax (or exempt from tax) will be no worse off as a result of these changes, and may find opportunities for investment. It would be no surprise if the spectre of this legislation brings into play “price chip” discussions as cash-rich investors seek to capitalise on uncertainties that inevitably will feature in the minds of sellers. ________________________ [1]  See HM Treasury and HM Revenue & Custom Autumn Budget 2017 – Open Consultation on Taxing gains made by non-residents on UK immovable property (22 November 2017), available athttps://www.gov.uk/government/consultations/taxing-gains-made-by-non-residents-on-uk-immovable-property   The following Gibson Dunn lawyers assisted in preparing this client update: Nicholas Aleksander, Jeff Trinklein, Alan Samson, and Barbara Onuonga. Gibson Dunn’s lawyers are available to assist with any questions you may have regarding these developments. For further information, please contact the Gibson Dunn lawyer with whom you usually work or any of the following members of the Tax Practice Group and Real Estate Practice Group: Nicholas Aleksander – London (+44 (0)20 7071 4232, naleksander@gibsondunn.com) Jeffrey M. Trinklein – London/New York (+44 (0)20 7071 4224 +1 212-351-2344), jtrinklein@gibsondunn.com) Alan Samson – London (+44 (0)20 7071 4222, asamson@gibsondunn.com)   © 2017 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.